The Three Primary Types of Financial Capital
When analyzing your business or a potential investment, it is important for you to know the three categories of financial capital: equity capital, debt capital, and specialty capital. There's also sweat equity, which is harder to estimate but useful for evaluating a small business. In this article, I'll explain each one in detail and what they mean for your business/investment.
There are some businesses that are funded entirely with equity capital, which is cash invested by the shareholders or owners into the company that has no offsetting liabilities. Although it is the favored form of capital for most businesses because they don't have to pay it back, it can be extraordinarily expensive. In addition, it could require massive amounts of work to grow their enterprises if they are funded this way. Microsoft is an example of such an operation because it generates high enough returns to justify a pure equity capital structure.
This type of capital is infused into a business with the understanding that it must be paid back at a predetermined date. In the meantime, the owner of the capital (typically a bank, bondholders, or a wealthy individual), agree to accept interest in exchange for you using their money. Think of interest expense as the cost of “renting” the capital to expand your business; it is often known as the cost of capital.
For many young businesses, debt can be the easiest way to expand because it is relatively easy to access and is understood by the average American worker thanks to widespread home ownership and the community-based nature of banks. The profits for the owners is the difference between the return on capital and the cost of capital; for example, if you borrow $100,000 and pay 10% interest yet earn 15% after taxes, the profit of 5%, or $5,000, would not have existed without the debt capital infused into the business.
This is the gold standard, and something you would do well to find. There are a few sources of capital that have almost no economic cost and can take the limits off of growth. They include things such as a negative cash conversion cycle (vendor financing), insurance float, etc. Let me explain.
- Negative Cash Conversion (Vendor Financing)
Imagine you own a retail store. To expand your business, you need $1 million in capital to open a new location. Most of the capital will be spent on buying or renting the property, product displays, cash registers and equipment, purchasing inventory to stock your shelves, and hiring new employees. You wait and hope that one day customers come in and pay you. In the meantime, you have capital (either debt or equity capital) tied up in the business in the form of inventory. Now, imagine if you could get your customers to pay you before you had to pay for your merchandise. This would allow you to carry far more merchandise than your capitalization structure would otherwise allow. AutoZone is a great example; it has convinced its vendors to put their products on its shelves and retain ownership until the moment a customer walks up to the front of one of AutoZone’s stores and pays for the goods. At that precise second, the vendor sells it to AutoZone which in turn sells it to the customer. This allows them to expand far more rapidly and return more money to the owners of the business in the form of share repurchases (cash dividends would also be an option) because they don’t have to tie up hundreds of millions of dollars in inventory. In the meantime, the increased cash in the business as a result of more favorable vendor terms and/or getting your customers to pay you sooner allows you to generate more income than your equity or debt alone would permit. Typically, vendor financing can be measured in part by looking at the percentage of inventories to accounts payable (the higher the percentage, the better), and analyzing the cash conversion cycle; the more days “negative”, the better. Dell Computer was famous for its nearly two or three week negative cash conversion cycle which allowed it to grow from a college dorm room to the largest computer company in the world with little or no debt in less than a single generation. Sam Walton built Wal-Mart on this principle and look where that got him - the Walton family is worth over $100 billion!
Insurance companies that collect money and can generate income by investing the funds before paying them out to policyholders when a car is damaged, when a home is destroyed by a tornado, or when a business is flooded are in a very good place. As Buffett describes it, float is money that a company holds but does not own. It has all of the benefits of debt but none of the drawbacks; the most important consideration is the cost of capital – that is, how much money it costs the owners of a business to generate float. In exceptional cases, the cost can actually be negative; that is, you are paid to invest other people’s money plus you get to keep the income from the investments. Other businesses can develop forms of float but it can be very difficult.
There is also a form of capital known as sweat equity, which is when an owner bootstraps operations by putting in long hours at a low rate of pay per hour.
This makes up for the lack of capital necessary to hire sufficient employees to do the job well and let them work an ordinary forty-hour workweek. Although it is largely intangible and does not count as financial capital, it can be estimated as the cost of payroll saved as a result of excess hours worked by the owners. The hope is that the business will grow fast enough to compensate the owner for the low-pay, long-hour sweat equity he or she infused into the enterprise.