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What is Capital?

definition

Capital refers to the assets — from buildings to machines to cash — that a company puts to work to make money.

🤔 Understanding capital

Capital is the lifeblood of wealth creation. Combined with labor, capital can be put to work to generate a profit for a business’s investors. Capital includes assets that a company uses to generate income, such as real estate, computers, equipment, and vehicles. Capital differs from money, which can be used to buy capital but also anything else that’s for sale. A company’s working capital is the difference between its current assets (those that can easily be converted to cash within a year) and current liabilities (debts owed within a year). Companies need sufficient working capital to stay in business. Firms often raise capital through equity (selling shares to investors) or debt (taking out loans or selling bonds).

example

A McDonald’s franchise employs capital and labor to make a profit. The restaurant’s staff makes up the labor portion. The capital includes the restaurant building, equipment (everything from the deep fryers to the cash registers), and working capital (cash) used to buy ingredients and pay employees. Inventory, such as frozen hamburger patties and fries, are also part of working capital. Without capital, the McDonald’s would not be able to generate wealth for its franchisee owner — or the corporation collecting franchise fees.

Takeaway

Capital is like yeast...

You need capital in order to put labor to work. Combine the raw ingredients (labor) and the yeast (capital), and a business can operate. When you invest in a company, you are helping it raise the capital it needs.

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Tell me more...

What’s the difference between capital and money?
What is capital in the economy?
What is capital in accounting and finance?
What is equity capital?
What is debt capital?
What is working capital?

What’s the difference between capital and money?

It’s easy to mix up capital with money. The key distinction is that capital refers to the resources a business puts to work to create products and services and grow wealth. You use money to buy capital assets (like factories, machinery, and vehicles), and the value of capital can be measured in terms of dollars. But money itself is not capital, and you can also use money to buy anything else available on the market. Money is mainly a way to trade one good for another.

What is capital in the economy?

Capital can drive economic growth and job creation, which makes it not only the “yeast” for an individual business but also for the economy as a whole. When the economy is booming, there is plenty of capital to go around, and businesses find it easier to raise capital by selling stock or taking on debt. Sometimes the amount of capital available for investment may exceed profitable opportunities. This can result in businesses with poor prospects obtaining capital they would not qualify for in tighter times.

When the economy is weak, capital often becomes scarce. Investors are more conservative, choosing lower-risk opportunities. In this environment, even strong businesses can have a hard time finding capital to grow.

Capital is at the root of the economic cycle. When the economy is doing well, people are motivated to invest their money into capital. 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 is cheaper, and demand for capital goes up. With more invested into capital assets, the hope is that this leads to economic growth and (indirectly) job creation.

What is capital in accounting and finance?

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.

What is equity capital?

Businesses need capital in order to operate and grow, but they don’t need to have it all on hand upfront. One option is for companies to raise equity capital by selling stock. Equity doesn’t mature like debt — Equity holders do not expect to redeem their shares for cash by a set date. Equity represents direct ownership in the business, so if the company generates wealth, owners may profit through dividends or selling their shares.

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. Companies use the equity capital they raise, along with other types of capital, to operate and generate profits.

What is debt capital?

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 also typically comes with interest, or an additional cost that must be paid regularly for the privilege of borrowing. The interest rate a business pays depends 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, this includes 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).

What is working capital?

Working capital represents a business’s day-to-day operating capital. The formula for working capital is:

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 is 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.

Working capital 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.

Certain current assets are more liquid than others. Liquidity refers to how quickly an asset can be converted to cash without affecting its price. Obviously, 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.

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