Financial Capital, Its Types, and Its Critical Role in the Economy
How Capital Is Used in Business and Economics
Financial capital is the money, credit, and other forms of funding that build wealth. Individuals use financial capital to invest, by making a down payment on a home or creating a portfolio for retirement.
Capital in Business
In business accounting, capital is how companies invest in their businesses. They use financial capital to buy more equipment, buildings, or materials. Managers can't use the money to give themselves raises, increase dividends, or lower prices. They must use it to produce greater future gains. A business uses this investment capital to transform itself into something more profitable.
Types of Business Capital
There are three types of financial capital in the business world. The first is debt. Companies receive capital now that they pay back with interest. At first, many entrepreneurs borrow from family members or their credit cards. Once they have a track record, they can get bank loans and federal government assistance from the Small Business Administration.
As these businesses continue to grow, they become large enough to issue individual bonds to investors. The advantage of debt is that owners don't have to share the profits. The disadvantage is that they must repay the loan even if the business fails.
The second type of capital is equity. The business receives cash now from investors for a share of the profits later. Most entrepreneurs use their own cash to get started. They put their own equity into the business in hopes of receiving 100 percent of the return later. If the company is profitable, they forgo spending some of the cash flow now and instead invest it in the business.
A larger firm gets equity from partners, venture capitalists, or angel investors. It must give up some control and ownership of the business in exchange for the cash.
Once a company becomes really large and successful, it can get additional capital from issuing stocks. This is called an initial public offering. It means any investor can purchase the company's stock.
The third type of capital is specialty capital. It's extra cash flow that comes from managing the company's operations better.
Vendor financing is when the company's suppliers are willing to accept delayed payment for their goods or services.
A popular form of specialty capital is supply chain financing. It's like a pay-day loan for businesses. Banks lend the company the amount of an invoice, minus a fee. They receive payment for the loan when the invoice is paid.
Company finance managers also create extra capital through investing wisely. In a bull market, some companies make more money from their investments than from their operations.
How a company creates and manages its capital is known as its capital structure. Most public companies use a combination of debt, through bonds, and equity, through various types of stock.
Many analysts use a simple formula, the debt-to-equity ratio, to determine how solid a company is. Companies with a ratio of 50 percent or more have more debt than equity. Analysts consider them to be highly leveraged and therefore riskier.
Another component of the capital structure is working capital. It's the cash on hand needed to run the company's operations. The formula is current assets minus current liabilities.
The working capital ratio is current assets divided by current liabilities. A working capital ratio of 2:1 means the company has enough liquidity to meet its immediate needs. If the ratio is higher, it means the company is not putting its money to use to build future profits.
Easy access to capital has been one of the most important drivers of U.S. economic success. America has the world's most sophisticated capital markets.
The transparency of the U.S. stock market allows investors to gain up-to-date information about every aspect of companies in which they might invest.
The U.S. bond market is serviced by the best investment banks in the world. They have the experience to walk the company through the bond process. They have the financial clout to underwrite the bonds and guarantee their success. And they have the contacts among investors to sell the bonds for the best price.
Financial Capital Versus Capital in Economics
Financial capital should not be confused with the economics term capital. It's one of the four factors of production that drive supply. That includes capital goods, such as machinery, equipment, and tools.
The other three factors are:
A market economy automatically provides these components of supply to meet demand from consumers.
Sometimes financial capital is called the fifth factor of production, although that's not exactly accurate. It facilitates production by providing income to the owners of production, but it is not itself a factor of production.