Understanding capital is essential to starting, growing, or evaluating a business of any size.
What is capital?
Nic Barnhart of Pareto Labs defines capital as simply, “Money that is used to make more money.” This definition can apply to individuals in the greater economy and to companies. In the world of business, the term capital means anything a business owns that contributes to building wealth.
Sources of capital include:
- Financial assets that can be liquidated like cash, cash equivalents, and marketable securities.
- Tangible assets such as the machines and facilities used to make a product.
- Human capital; i.e. the people that work to produce goods and services.
- Brand capital; i.e. the perceived value of a brand recognition.
What is the difference between capital and money?
The terms “capital” and “money” are certainly related, but they are not interchangeable. As a business owner, it’s important to know the difference.
Money is cash that you spend and capital is cash (or other asset) that you put to work. The money in your wallet isn’t a form of capital unless you put it to work earning you more money. People in finance often describe capital as having “greater durability” than money because it can be continuously re-invested to earn more value.
How is capital used?
“Think of the capital as the gas tank that powers the whole business.” – Nic Barnhart, cofounder of Pareto Labs
Capital is absolutely essential to a company getting off the ground—it’s like the first fill on the gas tank that will hopefully come to run a business that is profitable in the long term. Capital can be infused into the business at any time, to refuel the tank if it gets low.
For a business, capital is made up of two sources:
- Liabilities: Money that a business owes and that has to be paid back.
- Shareholders’ equity: Money that investors put into the company in exchange for ownership and that never has to be paid back.
Each company evaluates the right mix of liabilities and equity taking into account their risks, cost of capital, tax opportunities, and their ability to raise capital. That ideal mix becomes the business capital structure. Once a company finds the right debt-to-equity-ratio in their capital structure, they can begin using financial capital to make investments in the resources and securities that will build profitability.
On a balance sheet, capital and assets are equal. Capital is tied to the origin of the money—where it came from—while assets indicate how the business is putting their capital to work.
Top 4 types of capital for business
There are four common ways that businesses gather capital, whether it is to fund the company to launch or to help the company through a growth period. Working capital and debt and equity capital are sources of capital for any business, but trading capital is only found in companies in the financial space.
1. Working capital
Working capital—the difference between a company’s assets and liabilities—measures a company’s ability to produce cash to pay for its short term financial obligations, also known as liquidity.
Working capital = Current assets – Current liabilities
Positive working capital means the value of a company’s current assets is more than its current liabilities Negative working capital, on the other hand, means that current liabilities outweigh current assets. For the company, this could lead to financial issues with creditors, growth, or production.
2. Debt capital
Debt capital is acquired by borrowing from financial institutions, banks, friends and family, credit cards, federal loan programs, and venture capital, or by issuing bonds. Just like an individual needs established credit history to borrow, so do businesses.
Debt capital has to be paid off on a regular basis (with interest) but unlike an individual’s debt, it is seen as more of an essential part of building a business instead of a financial burden.
3. Equity capital
Equity capital is any capital raised through selling shares with a key difference being whether those shares are sold privately or publicly:
- Private: Shares of stock in a company within a private group of investors.
- Public: Shares of stock in a company that are listed on the stock exchange (think: IPO).
The money an investor pays for shares of stock in a company becomes equity capital for the business.
4. Trading capital
Trading capital applies exclusively to the financial industry where brokerage companies need enough capital to support their investment strategies. Trading capital supports the many daily trades that brokerage companies need to make to generate a profit and the large-scale trades made by the biggest brokerage firms. Sometimes it is granted to individual traders and sometimes to the firm as a whole.
Capital gains and capital losses
Capital gains and losses tell you how your investments performed. Capital gains are exactly as they sound—your invested capital gains value after an investment. Capital losses occur when your capital loses value after an investment.
Example: Capital gain
Let’s say that your business is a craft brewery startup. It’s time to scale up, and a brewery is selling a used brewery system that will triple your production. It needs repair and requires the purchaser to arrange for transport.
You invest $10,000 of your capital in purchasing the system, $5,000 in transit, and $750 in labor for repairs. Within the next year, you move your own production contract brewing and sell your brewing system for $25,000—recorded as a capital gain because you sold the asset for more than the purchase price plus costs for repair.
Example: Capital loss
Your craft brewery decides to open a taproom where you can sell your beer directly to consumers. You raise private equity capital to purchase a property for $2.5m. A year later, your P&L shows that while overall the company is profitable, the direct-to-consumer sales is suffering a loss. You sell the property for $2.1M—recorded as a capital loss because you sold the asset for less than the purchase price.
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