The capacity is lowered. To understand this you need to think about the shape of the battery. While it might look like a thin pouch or cylinder, that’s not the actual shape. The actual shape is two large sheets of thin metal with a soft chemical in between them. These are folded up or rolled up to get the familiar macro shape.
The thin metal, much thinner than aluminum foil, is easy to tear. When the foil tears, it makes a part of the sheet “disconnected” from the rest and the electrodes connecting it to your gadget. Any power stored in that part of the sheet is unavailable for use. The soft chemical can be squeezed out of position, any temperature above 95˚F/35˚C during charging makes this much more common. Without the chemical layer, the battery can short, which is another cause of rips. In the worst case scenario a short can start a fire, lithium battery fires can be spectacular and dangerous. That’s why you can’t ship these batteries in the cargo part of an airplane.
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