What is Capital?
In economics, capital consists of assets used for the production of goods and services. A typical example is the machinery used in factories. Capital can be increased by human labor, and does not include certain durable goods like homes and personal automobiles that are not used in the production of saleable goods and services.
In the business world, the term ‘capital’ is an integral part of driving business and building an economy. Companies have capital structures that include equity capital, debt capital and working capital for day-to-day operations. People hold capital as well as the capital assets as the net worth. The manner and quantum in which the individuals and companies finance their working capital is of paramount importance as the investment in capital is essential for development and return on investment.
Capital refers to financial assets, such as funds in the form of deposit accounts and funds got from special financing sources. Capital can also be relatable with the capital assets of a company that requires a significant capital contribution to finance or develop.
Capital can remain as financial assets or be raised from debt or equity financing. Businesses mostly have three options for business capital: working capital, equity capital, and debt capital. In general, business capital is the essence of running a business and funding capital intensive assets.
Capital assets are those assets of a business which include the current or long-term portion of the balance sheet. Capital assets include cash, cash equivalents, and marketable securities as well as plant and equipment, production facilities, and storage facilities.
What Does Capital Mean?
Capital is a broad term that can describe any thing that confers value or benefit to its owner, such as a factory and its machinery, intellectual property like patents, or the financial assets of a business or an individual. While money itself may be construed as capital is, capital is more often associated with cash that is being put to work for productive or investment purposes.
In general, capital is a critical component of running a business from day to day and financing its future growth. Business capital may derive from the operations of the business or be raised from debt or equity financing. When budgeting, businesses of all kinds typically focus on three types of capital: working capital, equity capital, and debt capital. A business in the financial industry identifies trading capital as a fourth component.
Capital is anything that increases your ability to generate value. You can use capital to increase value in your business’s financial assets. Generally, business capital includes financial assets held by your company that you can use to leverage growth and build financial stability.
Capital and cash are not one and the same. Capital can be stronger than cash because you can use it to produce something and generate revenue and income (e.g., investments). But because you can use capital to make money, it is considered an asset in your books (i.e., something that adds value to your business).
So, how does capital work? Companies can use capital to invest in anything to create value for their business. The more value it creates, the better the return for the business.
Sources of capital include:
- Financial assets that can be liquidated like cash, cash equivalents, and marketable securities.
- Tangible assets such as the machines and facilities used to make a product.
- Human capital; i.e. the people that work to produce goods and services.
- Brand capital; i.e. the perceived value of a brand recognition.
What is the Difference Between Capital and Money?
The terms “capital” and “money” are certainly related, but they are not interchangeable. As a business owner, it’s important to know the difference.
Money is cash that you spend and capital is cash (or other asset) that you put to work. The money in your wallet isn’t a form of capital unless you put it to work earning you more money. People in finance often describe capital as having “greater durability” than money because it can be continuously re-invested to earn more value.
Why is Capital Important?
Capital functions a vital role in the modern productive system as follows:
- Production without capital is not possible. Elaborate tools and sophisticated equipment are required for modern-day production.
- It increases the productivity of employees and in turn, the economy as a whole. Importance to technology and specialisation alongside a growing population has left manufacturers to arrange for more capital and allied resources to fulfil the demands.
- Capital accumulation is said to be the core of economic development. The economy may be a free enterprise economy found in America or a socialist seen in Soviet Russia or a mixed economy like that of India. Irrespective of these types, economic development needs critical ingredient, such as capital formation.
- Capital helps in creating employment opportunities. Workers are employed to produce capital goods as well as consumer goods.
So, what does capital include? Capital can expand to a variety of things in business, both tangible and intangible. Here are a few examples of capital:
- Company cars
- Brand names
- Bank accounts
There are also different types of capital in business, including:
- Working capital
- Use this capital to pay for day-to-day business operations
- Converts into cash more quickly than other investments (e.g., a new oven at a bakery)
- Debt capital
- Capital a business earns from taking out loans and debt
- Equity capital
- Comes in several forms, including public equity and private equity (e.g., shares of stock in the company)
- Trading capital
- Amount of money available to a company for purchasing and selling assets
How Capital Is Used
Capital is used by companies to pay for the ongoing production of goods and services in order to create profit. Companies use their capital to invest in all kinds of things for the purpose of creating value. Labor and building expansions are two common areas of capital allocation. By investing capital, a business or individual seeks to earn a higher return than the capital’s costs.
At the national and global levels, financial capital is analyzed by economists to understand how it is influencing economic growth. Economists watch several metrics of capital including personal income and personal consumption from the Commerce Department’s Personal Income and Outlays reports. Capital investment also can be found in the quarterly Gross Domestic Product report.
Typically, business capital and financial capital are judged from the perspective of a company’s capital structure. In the U.S., banks are required to hold a minimum amount of capital as a risk mitigation requirement (sometimes called economic capital) as directed by the central banks and banking regulations.
Other private companies are responsible for assessing their own capital thresholds, capital assets, and capital needs for corporate investment. Most of the financial capital analysis for businesses is done by closely analyzing the balance sheet.
Top 4 types of Capital for Business
There are four common ways that businesses gather capital, whether it is to fund the company to launch or to help the company through a growth period. Working capital and debt and equity capital are sources of capital for any business, but trading capital is only found in companies in the financial space.
1. Working capital
Working capital—the difference between a company’s assets and liabilities—measures a company’s ability to produce cash to pay for its short term financial obligations, also known as liquidity.
Working capital = Current assets – Current liabilities
Positive working capital means the value of a company’s current assets is more than its current liabilities Negative working capital, on the other hand, means that current liabilities outweigh current assets. For the company, this could lead to financial issues with creditors, growth, or production.
2. Debt capital
Debt capital is acquired by borrowing from financial institutions, banks, friends and family, credit cards, federal loan programs, and venture capital, or by issuing bonds. Just like an individual needs established credit history to borrow, so do businesses.
Debt capital has to be paid off on a regular basis (with interest) but unlike an individual’s debt, it is seen as more of an essential part of building a business instead of a financial burden.
3. Equity capital
Equity capital is any capital raised through selling shares with a key difference being whether those shares are sold privately or publicly:
- Private: Shares of stock in a company within a private group of investors.
- Public: Shares of stock in a company that are listed on the stock exchange (think: IPO).
The money an investor pays for shares of stock in a company becomes equity capital for the business.
4. Trading capital
Trading capital applies exclusively to the financial industry where brokerage companies need enough capital to support their investment strategies. Trading capital supports the many daily trades that brokerage companies need to make to generate a profit and the large-scale trades made by the biggest brokerage firms. Sometimes it is granted to individual traders and sometimes to the firm as a whole.
Capital Gains and Capital Losses
Capital gains and losses tell you how your investments performed. Capital gains are exactly as they sound—your invested capital gains value after an investment. Capital losses occur when your capital loses value after an investment.
Example: Capital gain
Let’s say that your business is a craft brewery startup. It’s time to scale up, and a brewery is selling a used brewery system that will triple your production. It needs repair and requires the purchaser to arrange for transport.
You invest $10,000 of your capital in purchasing the system, $5,000 in transit, and $750 in labor for repairs. Within the next year, you move your own production contract brewing and sell your brewing system for $25,000—recorded as a capital gain because you sold the asset for more than the purchase price plus costs for repair.
Example: Capital loss
Your craft brewery decides to open a taproom where you can sell your beer directly to consumers. You raise private equity capital to purchase a property for $2.5m. A year later, your P&L shows that while overall the company is profitable, the direct-to-consumer sales is suffering a loss. You sell the property for $2.1M—recorded as a capital loss because you sold the asset for less than the purchase price.
Cost of Capital
In a financial context, there is an associated cost of acquiring capital to run a company.
The cost of debt is based on the coupon, interest rate, and yield to maturity of the debt. For example, if a company borrows $5 million and must pay $0.5 million in annual interest, it’s cost of debt would be 10%.
Since the interest expense is tax-deductible, the after-tax cost of debt is equal to the interest rate multiplied by one minus the tax rate. Continuing with the example above, if the company’s tax rate is 25%, the after-tax cost of debt would be 10% x (1 – 25%) = 7.5%.
The cost of equity is an implied cost that is calculated using the Capital Asset Pricing Model (CAPM), which uses the riskiness of an investment (the volatility of its returns) as a means of determining how much it should cost per year. The cost of equity is always higher than the cost of debt because it carries more risk (in the event of insolvency, debt is repaid before equity). To learn more, read CFI’s guide to the weighted average cost of capital (WACC).