What is capital?
In a business context, capital refers to all the financial resources or capital assets held by a business that enables the business to produce goods and/or to deliver services, generating revenue and increasing value.
Put differently, capital in a business is anything that leverages growth and enhances financial stability.
A business’s capital assets are reported on its balance sheet and can comprise cash, materials, equipment, and buildings.
In addition, employees, patents, trademarks, and investments, are also included in a business’s capital resources.
The difference between capital and money
Generally, the terms money and capital may come across as the same thing. However, they are certainly not.
Capital is a much broader term than money, describing all the resources available to a business to generate revenue and to build wealth. Capital includes money.
Money, the currency of a particular country, is a medium of exchange that is used for the purchase or sale of services and goods.
Types of business capital
Business capital can be categorised into three broad categories, namely financial capital, human capital, and natural capital.
Financial capital
Financial capital refers to anything that is owned by a business and that has monetary value and is utilised to generate future revenue.
Financial capital includes, inter alia, the following types of capital: equity capital, debt capital, working capital, and trading capital.
Equity capital
Equity capital[1], also called share capital, is raised by a company when it issues shares to investors (individuals and entities). Put differently, when an investor buys shares of a company, he or she is providing equity capital to a company and owns a portion of the company.
Public traded companies raise equity capital via listings on stock exchanges, while private companies obtain equity capital from private investors (shareholders).
Some small businesses make use of angel financing, an investment model wherein ‘business angels’, also called ‘angel investors’ or ‘private investors’, provide capital for small businesses in exchange for equity in the company.
Equity capital is also referred to as residual capital, meaning shareholders have last entitlement to the assets of a company when it is sold or wound down.
Contrary to debt capital, there are no interest expenses or repayments involved in equity capital.
Debt capital
Debt capital refers to money borrowed by businesses from different capital resources.
Typically, big and established companies borrow from financial institutions, such as banks. Often, small businesses experience difficulties to borrow from financial institutions, compelling them to borrow from family, friends, or individuals who have an inclination to support small promising businesses.
Contrary to equity capital, there are repayments and cost of money (interest) involved in debt capital.
Borrowing money in order to purchase assets or to expand operations is called financial leverage, leverage, or debt leverage. The purpose is to use the borrowed capital to pay for an investment or project in the future and to increase the potential returns from a project or investment.
However, if the investment or project does not work out as expected or planned, the leverage will also increase the downside risk of a potential loss if the investment or project is a failure.
When a company is described as ‘highly leveraged’, it means that the company has more debt than equity.
Therefore, it is important that the management of a business and its investors take note of a company’s debt-to-capital ratio in order to avoid borrowing too much money.
The debt-to-capital ratio is a liquidity ratio used in accounting to measure a company’s financial leverage by comparing its total debt obligations (debt capital) to its total equity capital.
The formula for the debt-to-capital ratio is:
Debt-to-capital ratio = Total debt/Total debt + Shareholders’ equity
Where:
- Total debt comprises all of a company’s short-term and long-term liabilities. (Short-term liabilities are repayable within a time frame of one year or less, while borrowers of long-term debt obligations are allowed a year and longer to repay their debt.)
- Shareholders’ equity includes, inter alia, ordinary shares, and preference shares.
Normally, the higher the debt-to-capital ratio, the more a company utilises debt capital than equity capital, putting the company at risk of default[2] on its debt.
Working capital
Working capital, also called net working capital (NWC), refers to the capital that is available to a business for performing its daily operations.
NWC is an indication of a company’s operational effectivity and short-term financial health, representing the company’s short-term liquidity – the ability to serve all its short-term debt obligations also referred to as current liabilities.
Working capital is calculated by deducting current liabilities from current assets.
Where:
- Current assets include assets such as cash and cash equivalents, prepaid expenses, inventory, and accounts receivable.
- Current liabilities comprise short-term debt obligations like accounts payable, short-term bank loans, and taxes payable.
Trading capital
In the trading of securities and forex, trading capital refers to the amount of money made available to buy and sell securities and forex. It is a term used by brokerages, financial institutions, and traders that trade a considerable number of trades daily.
Securities markets have requirements of a legal minimum of trading capital before a brokerage or trader can start trading.
Human capital
Human capital refers to human abilities and qualities that can improve a business’s economic output and productivity, increasing earnings.
Human capital is an intangible asset. However, it is not reported on a company’s balance sheet.
Human capital includes, inter alia, the following qualities and skills:
- Education
- Training
- Communication skills
- Intelligence
- Health
- Emotional intelligence
- People management
- Punctuality
- Problem-solving
- Technical qualifications
- Mental and emotional well-being
The more a business invests in its human capital, improving the qualities and skills of its managers and employees, the more the productivity of the business will improve, increasing the value of the business.
Natural capital
Natural capital refers to natural assets or resources (renewable and non-renewable) that can be utilised by businesses to increase production, generate revenue, contributing to the value of the business.
Businesses may or may not own the natural resources required to increase their production.
Examples of natural resources or assets are:
- Commodities such as crude oil, precious metals (gold, silver), and crude oil
- Animals
- Forest plantations
- Crops
- Wind power
- Solar power
Natural capital is a type of asset; hence, it will be reported on a company’s balance sheet.
[1] See the article, ‘Equity Explained for Dummies’, for more information on equity.
[2] Refer the article, ‘Default in Finance Explained for Dummies,’ for detail about defaulting on debt.
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