There are three types of financial capital: equity, debt, and specialty. There's also sweat equity, which can be harder to gauge but is still helpful to keep in mind. This is especially true when you're looking at a small or startup business.
Learn more about the three main types of capital and how they can help you assess your own business or someone else's.
Type One: Equity Capital
Also known as “net worth” or “book value," this portrays a company's assets minus its liabilities. Some businesses are funded with equity capital alone. This may come in the form of cash invested by the shareholders or owners into a company that has no offsetting liabilities.
This is the favored form of capital for most businesses. That's because they don't have to pay it back. But it can be very costly. It can also demand massive amounts of work to grow an enterprise that's been funded this way.
Microsoft is an example of this type of operation. It makes high enough returns to justify a pure equity capital structure.
Type Two: Debt Capital
This type is money given as a loan with the understanding that it must be paid back by a certain date. The owner of the capital is often a bank, bondholder, or wealthy person. They agree to accept interest payments in exchange for you using their money.
Think of interest expense as the cost of “renting” the money to expand your business. It's often known as the cost of capital. About 80% of U.S. small businesses are said to rely on credit at least in part.
The Small Business Administration (SBA) administers many venture capital programs to startups and small businesses. These include long-term loans and loan guaranty programs; these help small businesses obtain funding from other sources.
Debt can be an easy way to expand for many young businesses. It's fairly easy to access and understand.
The profit for a business owner is the difference between the return on capital and the cost of capital. For instance, a profit of 5% or $5,000 wouldn't exist without the debt capital borrowed by the business if it borrowed $100,000 and paid 10% interest yet earned 15% after taxes.
Type Three: Specialty Capital
This is the gold standard, and it's something you would do well to find as a business owner. There are a few sources of capital that have almost no economic cost and can take the limits off growth. They include the negative cash conversion cycle or vendor financing, and insurance floats.
Negative Cash Conversion
Let's say you own a retail store. You need $1 million in capital to open a new location in order to expand. Most of that money will be spent on buying or renting the property, product displays, equipment, buying inventory to stock your shelves, and hiring new workers.
You open your doors and hope that customers come in and buy the items you're selling. In the meantime, your capital is tied up in the form of inventory. That capital may be either debt or equity capital, or both.
Now, let's say that you could get your customers to pay you before you have to pay for your items. This would allow you to carry far more products than your capitalization structure would otherwise allow. This can be done through vendor financing.
An Example of Vendor Financing
Let's say ABC company convinced its vendors to put their products on its shelves and retain ownership until the moment a customer walks to the front of the store and pays for the goods. The vendor sells it to ABC at that precise moment. In turn, they sell it to the customer.
This allows ABC locations to expand far more quickly and return more money to the owners of the business in the form of share repurchases. Cash dividends would also be an option. They don’t have to tie up hundreds of millions of dollars in inventory.
The increased cash in the business as a result of more favorable vendor terms and/or getting customers to pay sooner allows the business to generate more income than equity or debt capital alone would permit.
Vendor financing can be measured by looking at the percentage of inventories to accounts payable. The higher the percentage, the better. You'll also need to analyze the cash conversion cycle. In this case, more days “negative” is better.
Insurance companies are a good example when it comes to understanding the concept of float. They collect money and generate income by investing those funds before paying benefits out to their clients. They hold onto and use the money until a car is wrecked, when a home is destroyed by a storm, or when an office is flooded.
"Float" is money that a company holds but doesn't own. It has all the benefits of debt equity but none of the drawbacks. The most important consideration is the cost of capital: how much money it costs the owners of a business to generate float.
The cost can actually be negative in certain cases, such as when you're paid to invest other people’s money and you get to keep the income.
Other types of businesses can develop forms of float, but it may not be easy.
"Sweat equity" is built when an owner, and sometimes key employees, bootstrap operations. They may put in long hours at a low rate of pay per hour. Or, they may not get any pay at all. This makes up for the lack of capital necessary to hire the employees needed to do the job.
Sweat equity is largely intangible, and it doesn't count as financial capital. But 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 make up for the low-pay, long-hour sweat equity they put into the company.