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What is capital?

Understanding capital
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Looking for a capital definition? The broadest description of capital would include not only cash in the bank, equity capital, debt capital and similar, but plant, machinery, warehouses, vehicles and even valuable brand names. However, while it is quite valid to include this second group of assets in the definition of capital, we will be looking, in the main, at the financial aspects of capital.

Where have you heard about capital?

The short answer is – everywhere. As an investor, you will find mentions of capital impossible to avoid, whether in the reports of companies in which you are invested or in the financial media, investment guides or discussions with your financial adviser. Investment firms will offer to protect and enhance your capital, while businesses seeking to raise funds will announce their intention to tap stock exchanges and debt capital markets. When wealthy investors flee a country, you may well see this described as ‘capital flight’.

What you need to know about capital…

Capital describes the total stock of financial assets available to an individual or a business. In the former case, the capital structure is usually fairly simple, comprising short-term savings, retirement funds, cash in the bank and the financial value of assets such as a family home or other property.

For a company, the whole business of capital is rather more complicated. The first thing to bear in mind is that corporate capital includes both financial assets owned by the company, such as bank deposits, and those that it will have to repay in due course, such as debt capital raised through the sale of corporate bonds.

This may seem confusing, as few households would count as assets their overdraft or credit-card bill. But credit is the lifeblood of business, and capital is defined not solely as corporate property, but as the resources that can be deployed by the company concerned.

A question of equity

Equity capital is the backbone of the modern company’s financial structure. It does not have to be publicly quoted on a stock exchange – indeed, there has been a trend away from share flotations in recent years. Nor does it have to provide the bulk of the capital of the firm concerned.

Equity, quite simply, is a type of financial investment in a business and usually carries ownership rights in that business. These rights may be seen as compensation for the fact that the investment does not need to be repaid.

Commonly, equity capital will be initially subscribed by the founders of the company, with each receiving shares in proportion to their investment. Later, if the company is successful, some (or all) of the stock may be offered to the public, but the principle remains the same – in return for the risk that the investors are taking, they are usually (but not always) given a piece of the ownership and control of the business.

They will be entitled also to any dividends that may be paid, although these can be distributed only once all debt obligations, such as interest on loans, have been met.

Debt capital, short and long-term

As the name suggests, debt capital in all its various forms describes a loan of one sort or another. It doesn’t have to be a bank loan (although that would certainly qualify) nor, on the other hand, need they be corporate bonds with a maturity date some years in the future (although these, too, count as debt capital).

Essentially, debt capital forms the part of a company’s financial structure that is ultimately owed to external creditors, who will also be entitled to interest payments or bond dividends. Unlike dividends on equity, the payments due on debt capital are almost always fixed.

Debt holders, unlike equity owners, do not normally enjoy any ownership rights in the business.

Corporate bonds are probably the best-known type of lending to companies. Debt capital markets have greatly expanded over the years, and are deep and liquid, allowing reputable firms to meet their financing needs at a reasonable cost.

Types of corporate debt have also become increasingly complex, with different types of bonds or loans enjoying differing rankings in terms of where they would stand were the company to become insolvent and its assets divided among creditors.

In a typical structure, holders of senior debt would be paid first, of subordinated debt last and those owning ‘mezzanine debt’ (so called because it is slotted between the two) would rank in the middle.

Unsurprisingly, buyers of lower-ranked debt would usually expect a higher return to compensate for the greater risk.

Elsewhere in debt capital markets, companies can seek buyers for commercial paper, a much shorter-dated debt instrument, essentially an IOU payable, typically, in 30 or 90 days’ time.

Debt and equity

The relationship between a company’s debt and equity is known variously as ‘gearing’ or ‘leverage’. Traditionally, financial advisers have preferred the debt-equity ratio to be as low as possible, as it is seen as a sound capital position. But, views as to the appropriate blend of debt and equity will vary from company to company and industry to industry.

Occasionally, debt can be exchanged for equity. Holders of convertible bonds are entitled to trade in their debt on fixed dates for a set amount of equity, should they so wish.

Sometimes, an over-borrowed company will offer its creditors a ‘debt for equity’ swap, usually on generous terms that see the existing shareholders’ stakes heavily diluted.

Working and trading capital

Working capital is distinct from debt and equity capital in that it is an overall measure of a company’s short-term assets, regardless of their origin. Deducting a business’s short terms liabilities from its short-term assets gives a ratio for working capital.

Thus, anything over 1 suggests the company is in good shape to cover its short-term debts and generally pay its way. Anything under 1 means the company has negative working capital and may well find it hard to meet its obligations in the short term.

Ultimately, the inability to pay debts as they fall due is the definition of insolvency.

A secondary use of the working capital ratio is to gauge the efficiency of the company - too high a ratio may suggest either that it is slow to collect what is owed to the firm, or is failing to invest surplus money – or both.

Trading capital is quite different from the other types of capital that we have examined, in that it represents funds set aside for the buying and selling of securities. While it is quite possible for a business to hold trading capital, it is more usually associated with individual securities traders.

Find out more about capital…

Our glossary contains further and more detailed definitions of many of the expressions in this article, including stock exchange, dividendsinterest, maturity and commercial paper.

So-called patient capital – funds committed for the long term to help businesses to grow – has been much discussed recently.

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