Defining Capital
Capital is a versatile term representing anything that provides value or benefit to its owner—including a factory with its machinery, intellectual property like patents, or the financial assets of a business or individual. While money can be considered capital, it is typically associated with cash being utilized for productive or investment purposes. Essentially, capital is critical for daily business operations and financing future growth.
Businesses can derive capital from operations or raise it through debt or equity financing. Common sources include:
- Personal savings
- Friends and family
- Angel investors
- Venture capitalists (VC)
- Corporations
- Federal, state, or local governments
- Private loans
- Business operations
- Initial Public Offering (IPO)
When budgeting, businesses often focus on three capital types: working capital, equity capital, and debt capital. Financial industries may consider a fourth type: trading capital.
Key Takeaways
- Capital is the financial resource available for day-to-day operations and future growth.
- Major types of capital include working capital, equity capital, debt capital, and trading capital (specifically for financial institutions).
- Companies finance their capital needs through a mix of debt and equity, impacting their capital structure.
- Economists evaluate a family, business, or economy’s efficiency based on its capital use.
Understanding Capital
From an economic perspective, capital is essential for the functioning of any entity, whether a family, business, or entire economy. Listed on balance sheets as either current or long-term assets, capital assets include:
- Cash and cash equivalents
- Marketable securities
- Manufacturing equipment
- Production facilities
- Storage facilities
Broadly, capital is both a measure of wealth and a resource for generating more wealth, impacting individuals’ net worth or companies’ capital structures incorporating debt, equity, and working capital.
How Capital Is Used
Businesses utilize capital to produce goods and services, investing in areas like labor or building expansions to create value. Capital investment aims to earn a higher return on investment than the associated costs.
Economists analyze financial capital at the national level to gauge its impact on economic growth. Metrics include personal income and consumption data from the Commerce Department and capital investments from quarterly GDP reports.
Businesses assess their capital structure through balance sheets, differentiating assets, liabilities, and equity.
Business Capital Structure
A company’s balance sheet offers insights into its capital structure, divided among assets, liabilities, and equity. Two main financing types include debt (requiring scheduled repayments with interest) and equity (via stock shares). Key metrics for analyzing business capital include:
- Weighted average cost of capital
- Debt to equity ratio
- Debt to capital ratio
- Return on equity
Types of Capital
Debt Capital
Businesses acquire capital by borrowing privately or from government sources. Established companies often borrow from banks or issue bonds, while small businesses might rely on friends, family, online lenders, or credit card companies. Debt capital requires repayment with interest, with rates depending on the capital type and borrower’s credit history.
Example: U.S. corporations often issue bonds to raise capital, especially when interest rates are low. In 2020, corporate bond issuance surged by 70% compared to the previous year, driven by low average yields.
Equity Capital
Equity capital involves selling stock shares, with distinctions between private and public equity. Public equity is listed on stock exchanges, whereas private equity is raised among selected investors. Equity provides capital without the obligation of repayment.
Example: When an investor buys company stock, they provide equity capital. The largest equity capital events occur during IPOs, like Duolingo’s 2021 IPO, which valued the company at $5 billion.
Working Capital
Working capital refers to the liquid assets available for meeting daily obligations, calculated as:
- Current Assets - Current Liabilities
- Accounts Receivable + Inventory - Accounts Payable
This measure signifies a company’s capability to cover short-term liabilities. Insufficient working capital could indicate financial distress.
Fun Fact: If a company’s liabilities surpass its assets, it might face shortfalls in working capital.
Trading Capital
Trading capital specifically applies to brokerages and financial institutions engaged in frequent trading. By employing trade optimization methods, traders aim to manage their capital for maximum efficiency.
Example: Brokerage firms allocate substantial trading capital to professionals handling stock trades.
Capital vs. Money
At its core, capital is money. However, in financial and business contexts, it refers to resources allocated for current operations and future investments. Deploying capital involves costs such as interest on debt or shareholder distributions.
What Does Capital Mean in Economics?
To economists, capital represents liquid assets available for spending on immediate needs or long-term projects. On a global scale, capital encompasses all circulating money involved in economic activities.
What Is the Capital in a Business?
Business capital involves funds available for daily operations and future growth. Besides cash, capital assets might include real estate, machinery, and patents. Totaling up capital includes all valuable possessions minus liabilities.
What Are Examples of Capital?
Examples include proceeds from stock sales, bond issues, and business operations appearing as capital on a balance sheet.
What Are the 3 Sources of Capital?
Businesses differentiate between:
- Working Capital: Funds for daily operations and obligations.
- Equity Capital: Raised through public or private share issuance for business expansion.
- Debt Capital: Borrowed funds listed as assets while the owed amounts appear as liabilities.
The Bottom Line
Capital has various meanings, often context-dependent. On a balance sheet, capital is the available money for operations or new initiatives, classified as working, equity, or debt capital based on origin and purpose. For economists, capital often means cash in circulation globally. By understanding these distinctions, businesses and economists alike can make informed decisions for growth and efficiency.
Related Terms: investment capital, capital structure, financial capital, economic capital.
References
- Federal Reserve Board. “Policy Tools: Reserve Requirements”.
- Moody’s Analytics. “Corporate Bond Issuance Boom May Steady Credit Quality, On Balance”.
- St. Louis Fed. “Moody’s Seasoned Aaa Corporate Bond Yield”.
- CNBC. “Duolingo Closes Up 36% in Nasdaq Debut”.
- Bureau of Economic Analysis. “Personal Income”.
