Capital: Definition, How It’s Used, Structure, and Types in Business
What Is Capital?
Capital is a broad term that can describe anything that confers value or benefit to its owners, 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, 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. Common sources of capital include:
- Personal savings
- Friends and family
- Angel investors
- Venture capitalists (VC)
- Federal, state, or local governments
- Private loans
- Work or business operations
- Going public with an IPO
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.
Learn more about the types, sources, and structures of capital.
- The capital of a business is the money it has available to pay for its day-to-day operations and to fund its future growth.
- The four major types of capital include working capital, debt, equity, and trading capital. Trading capital is used by brokerages and other financial institutions.
- Any debt capital is offset by a debt liability on the balance sheet.
- The capital structure of a company determines what mix of these types of capital it uses to fund its business.
- Economists look at the capital of a family, a business, or an entire economy to evaluate how efficiently it is using its resources.
From the economists’ perspective, capital is key to the functioning of any unit, whether that unit is a family, a small business, a large corporation, or an entire economy.
Capital assets can be found on either the current or long-term portion of the balance sheet. These assets may include cash, cash equivalents, and marketable securities as well as manufacturing equipment, production facilities, and storage facilities.
In the broadest sense, capital can be a measurement of wealth and a resource for increasing wealth. Individuals hold capital and capital assets as part of their net worth. Companies have capital structures that define the mix of debt capital, equity capital, and working capital for daily expenditures that they use.
Capital is typically cash or liquid assets being held or obtained for expenditures. In a broader sense, the term may be expanded to include all of a company’s assets that have monetary value, such as its equipment, real estate, and inventory. But when it comes to budgeting, capital is cash flow.
In general, capital can be a measurement of wealth and also a resource that provides for increasing wealth through direct investment or capital project investments. Individuals hold capital and capital assets as part of their net worth. Companies have capital structures that include debt capital, equity capital, and working capital for daily expenditures.
How individuals and companies finance their working capital and invest their obtained capital is critical for their prosperity.
How Capital Is Used
Capital is used by companies to pay for the ongoing production of goods and services to create profit. Companies use their capital to invest in all kinds of things to create 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.1
Other private companies are responsible for assessing their 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.
Business Capital Structure
A company’s balance sheet provides for metric analysis of a capital structure, which is split among assets, liabilities, and equity. The mix defines the structure.
Debt financing represents a cash capital asset that must be repaid over time through scheduled liabilities. Equity financing, meaning the sale of stock shares, provides cash capital that is also reported in the equity portion of the balance sheet. Debt capital typically comes with lower rates of return and strict provisions for repayment.
Some of the key metrics for analyzing business capital are weighted average cost of capital, debt to equity, debt to capital, and return on equity.
Types of Capital
Below are the top four types of capital that businesses focus on in more detail
A business can acquire capital by borrowing. This is debt capital, and it can be obtained through private or government sources. For established companies, this most often means borrowing from banks and other financial institutions or issuing bonds. For small businesses starting on a shoestring, sources of capital may include friends and family, online lenders, credit card companies, and federal loan programs.
Like individuals, businesses must have an active credit history to obtain debt capital. Debt capital requires regular repayment with interest. The interest rates vary depending on the type of capital obtained and the borrower’s credit history.
Individuals quite rightly see debt as a burden, but businesses see it as an opportunity, at least if the debt doesn’t get out of hand. It is the only way that most businesses can obtain a large enough lump sum to pay for a major investment in the future. But both businesses and their potential investors need to keep an eye on the debt to capital ratio to avoid getting in too deep.
Issuing bonds is a favorite way for corporations to raise debt capital, especially when prevailing interest rates are low, making it cheaper to borrow. In 2020, for example, corporate bond issuance by U.S. companies soared 70% year over year, according to Moody’s Analytics.2 Average corporate bond yields had then hit a multi-year low of about 2.3%.3
Equity capital can come in several forms. Typically, distinctions are made between private equity, public equity, and real estate equity.
Private and public equity will usually be structured in the form of shares of stock in the company. The only distinction here is that public equity is raised by listing the company’s shares on a stock exchange while private equity is raised among a closed group of investors.
When an individual investor buys shares of stock, they are providing equity capital to a company. The biggest splashes in the world of raising equity capital come, of course, when a company launches an initial public offering (IPO). In 2021, the Duolingo IPO valued the company at $5 million and shook the Nasdaq market.4
A company’s working capital is its liquid capital assets available for fulfilling daily obligations. It is calculated through the following two assessments:
- Current Assets – Current Liabilities
- Accounts Receivable + Inventory – Accounts Payable
Working capital measures a company’s short-term liquidity. More specifically, it represents its ability to cover its debts, accounts payable, and other obligations that are due within one year.
Note that working capital is defined as current assets minus its current liabilities. A company that has more liabilities than assets could soon run short of working capital.
Any business needs a substantial amount of capital to operate and create profitable returns. Balance sheet analysis is central to the review and assessment of business capital.
Trading capital is a term used by brokerages and other financial institutions that place a large number of trades daily. Trading capital is the amount of money allotted to an individual or a firm to buy and sell various securities.
Investors may attempt to add to their trading capital by employing a variety of trade optimization methods. These methods attempt to make the best use of capital by determining the ideal percentage of funds to invest with each trade.
In particular, to be successful, traders need to determine the optimal cash reserves required for their investing strategies.
A big brokerage firm like Charles Schwab or Fidelity Investments will allocate considerable trading capital to each of the professionals who trade stocks and other assets for it.
Capital vs. Money
At its core, capital is money. However, for financial and business purposes, capital is typically viewed from the perspective of current operations and investments in the future.
Capital usually comes with a cost. For debt capital, this is the cost of interest required in repayment. For equity capital, this is the cost of distributions made to shareholders. Overall, capital is deployed to help shape a company’s development and growth.
What Does Capital Mean in Economics?
To an economist, capital usually means liquid assets. In other words, it’s cash in hand that is available for spending, whether on day-to-day necessities or long-term projects. On a global scale, capital is all of the money that is currently in circulation, being exchanged for day-to-day necessities or longer-term wants.
What Is the Capital in a Business?
The capital of a business is the money it has available to fund its day-to-day operations and to bankroll its expansion for the future. The proceeds of its business are one source of capital.
Capital assets are generally a broader term. The capital assets of an individual or a business may include real estate, cars, investments (long or short-term), and other valuable possessions. A business may also have capital assets including expensive machinery, inventory, warehouse space, office equipment, and patents held by the company.
Many capital assets are illiquid—that is, they can’t be readily turned into cash to meet immediate needs.
A company that totaled up its capital value would include every item owned by the business as well as all of its financial assets (minus its liabilities). But an accountant handling the day-to-day budget of the company would consider only its cash on hand as its capital.
What Are Examples of Capital?
Any financial asset that is being used may be capital. The contents of a bank account, the proceeds of a sale of stock shares, or the proceeds of a bond issue all are examples. The proceeds of a business’s current operations go onto its balance sheet as capital.
What Are the 3 Sources of Capital?
Most businesses distinguish between working capital, equity capital, and debt capital, although they overlap.
- Working capital is the money needed to meet the day-to-day operation of the business and pay its obligations promptly.
- Equity capital is raised by issuing shares in the company, publicly or privately, and is used to fund the expansion of the business.
- Debt capital is borrowed money. On the balance sheet, the amount borrowed appears as a capital asset while the amount owed appears as a liability.
The Bottom Line
The word capital has several meanings depending on its context.
On a company balance sheet, capital is money available for immediate use, whether to keep the day-to-day business running or to launch a new initiative. It may be defined on its balance sheet as working capital, equity capital, or debt capital, depending on its origin and intended use. Brokerages also list trading capital; that is the cash available for routine trading in the markets.
When a company defines its overall capital assets, it generally will include all of its possessions that have a cash value, such as equipment and real estate.
When economists look at capital, they are most often looking at the cash in circulation within an entire economy. Some of the major national economic indicators are the ups and downs of all of the cash in circulation. One example is the monthly Personal Income and Outlays report from the U.S. Bureau of Economic Analysis.5
- 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.”
Prepare and write by:
Author: Mohammed A Bazzoun
If you have any more specific questions, feel free to ask in comments.
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