What is Capital?

Capital is like yeast...

If you’re baking bread, you might start with some raw ingredients — water, flour, maybe a pinch of salt and sugar. But you probably need yeast to bring it all together. (Without it, things might fall flat.) Likewise, a company needs different factors of production to operate. With yeast, or capital, it has the potential to rise.

It’s easy to confuse capital and money. The key distinction is that capital refers to a company’s productive resources, the materials used to create products and services. By comparison, you use money to buy capital assets (like factories, machinery, and vehicles). The value of these assets can be measured in dollars, but money itself is not capital (it’s not productive). Money is mainly a way to trade one good for another.

Capital can also drive economic growth and job creation, making it the “yeast” for the economy as a whole. When the economy is booming, there’s plenty of capital to go around, and businesses may find it easier to raise capital by selling stock or taking out loans. Sometimes the amount of capital available for investment may exceed profitable opportunities. This can result in businesses with poor prospects obtaining capital they wouldn’t qualify for in tighter times.

When the economy is weak, capital often becomes scarce. Investors become more conservative, favoring lower-risk opportunities. In this environment, even strong businesses may have a hard time finding capital to grow or sustain operations.

Capital is at the root of the economic cycle. When the economy is doing well, people are motivated to invest their money. But when the economy appears headed for a downturn, investors get nervous, often hoarding money instead of putting it to work. Some economic policies are designed to reverse this dynamic and drive investment. A prime example is when the Federal Reserve, the country’s central bank, lowers interest rates. When interest rates are low, borrowing becomes cheaper, and demand for capital may rise. With more invested into capital assets, the hope is that this leads to economic growth and (indirectly) job creation.

In accounting and finance, capital represents the tangible assets of a business. These can be current assets (such as cash or cash equivalents) and long-term assets (such as property, plants, and equipment). These assets are listed on a company’s balance sheet.

Unlike labor or material costs, the cost of a capital asset like a vehicle or a computer is not accounted for in a single year in a company’s financial statements. For these long-term assets, businesses use an accounting concept called depreciation to divide the cost over several years.

Businesses need capital in order to operate and grow, but they don’t need to have it all on hand. One option is for companies to raise equity capital by selling stock. Equity doesn’t mature like debt — stockholders do not expect to redeem their shares for cash by some fixed date. Instead, shares represent direct ownership in the business, so if the company generates wealth, owners may profit by receiving dividends (a portion of profits) or potentially selling their shares at a higher price.

Private businesses raise equity capital through what are called private placements, which are open only to accredited investors (individuals with a high net worth or income, banks, insurers, and other sophisticated investors). Businesses that go public raise equity capital through the sale of stock to the general public and investment banks. Companies use the equity capital they raise, along with other types of capital, to operate and generate profits.

Businesses can also obtain debt capital through loans from individuals, financial institutions, and other lenders, or by selling bonds to investors. Unlike equity, debt has to be paid back to the investor within a fixed time period.

Debt typically comes with interest, or an additional cost that must be paid regularly for the privilege of borrowing. The interest rate a business pays on a loan may depend on its financial strength and credit rating. Small, riskier businesses typically pay higher interest rates than larger, more established companies.

Debt capital comes from many sources. For loans, these may include banks, credit unions, and other lending institutions. Public companies can also sell bonds to institutional investors, such as banks and investment funds. Privately held businesses can also raise debt capital through private placements (sale of securities not traded on a major market).

Working capital represents a business’s day-to-day operating capital.

This is the most commonly used measure of a company’s ability to satisfy short-term obligations (think of this as a business’s monthly bills). If a firm doesn’t have enough working capital, it may not be able to stay in business.

Working Capital = Current Assets - Current Liabilities

Current assets include things like cash, short-term fixed income securities, inventory, and accounts receivable. Inventory consists of the items a business sells, or in the case of a restaurant or manufacturing business, raw materials used to make the final product. Accounts receivable refers to what customers owe the company for sales or services it has already delivered.

Current liabilities include accounts payable, accrued expenses, and short-term debt. Accounts payable are expenses the company currently owes to its suppliers or vendors. Accrued expenses represent things like employees’ salaries that have not yet been paid.

Certain current assets are more liquid than others. Liquidity refers to how quickly an asset can be converted to cash without affecting its price. Cash is the most liquid asset. After that, short-term cash equivalents (such as money market accounts and short-term bonds) are the next most liquid. Current assets like inventory and accounts receivable are less liquid. While it may be easier than selling a piece of machinery or property, it still takes time to convert inventory into sales or collect on an invoice. Not having enough liquidity can be a problem if a company lacks enough cash to make payroll or pay vendors.