Capital

Capital is a broad term that can be used in a number of ways. Yet in this article we will focus on the definition of capital in financial markets, the so-called business capital, used by companies to expand and operate their business. 

What is capital?

Capital is the total stock of financial assets available to an individual or a business. It can describe everything from cash in the bank, equity capital, debt capital, 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 meaning of capital in business.

Key takeaways

Understanding business capital

Business 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.

What are sources of capital?

Capital is vital to any business, yet it needs to be obtained from somewhere. Generally, the four key sources of capital can be divided into: 

• Equity capital: money raised by selling company shares, publicly or privately.

• Debt capital: money borrowed from banks, individuals or institutions, for example, via corporate bonds. 

• Grants: Government grants and subsidies can be a source of business capital. There are a number of grant types available for businesses depending on the country they operate in. 

• Revenue: Business revenues, which is any money received from sales, trading and speculation, can also generate capital to reinvest back into the business. These would be in the form of cash or cash equivalents. 

Types of capital

There are various types of capital derived from either its source, or use cases. 

Equity capital

Equity capital is the backbone of the modern company’s financial structure. It does not have to be publicly quoted on a stock exchange, 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 in an initial public offering (IPO) or via special purpose acquisition company (SPAC) , 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

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.

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.The 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.

Working 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 term 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

Trading capital is quite different from the other forms of capital that we have examined, in that it represents funds set aside for the buying and selling of securities. 

This type of capital would be typical for firms who engage in high volumes of trading activity, for example hedge funds, asset managers and brokerages. 

What does capital mean in economics?

In economics, capital generally refers to any goods currently in use, or that can be used, for production and wealth. This would cover machinery, tools, equipment, buildings, transportation, technology, raw materials, and much more. 

In the words of British economist Sir John Richard Hicks:

What are examples of capital?

An example of capital would be any asset used by a company. For instance, company stocks and corporate bonds are examples of equity and debt capital respectively. Businesses can sell their shares and bonds, converting them into cash to fund business investment. 

Cash held in bank accounts, or money easily accessible - for example, undeposited client checks - is an example of working capital as it can be used promptly to fund day-to-day business operations. 

Any business equipment such as machinery, tools, and even real estate, can also be considered business capital from an economic standpoint, as these are goods used for production. 

Conclusion

Capital is an important concept to grasp for understanding corporate balance sheets as part of fundamental analysis of stocks. It’s a key metric in accessing a company’s financial health.

There are four main sources of business capital are equity, debt, government grants and business revenues.

Meanwhile, the four types of capital are based on its source or use case. These include equity capital, derived from selling company stock; debt capital sourced from debt such as corporate bonds; working capital that is used for funding day to day business expenses; and trading capital that’s typically set aside by financial institutions for trading securities.

In economics, capital can also refer to machinery and other equipment used by businesses for production.

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