The 3 Primary Types of Financial Capital
The three types of financial capital can influence your decision when you're analyzing your own business or a potential investment: equity capital, debt capital, and specialty capital. There's also sweat equity, which is harder to estimate but useful to understand—especially when it comes to evaluating a small or startup business.
Otherwise known as “net worth” or “book value," this figure represents a company's assets minus its liabilities. Some businesses are funded entirely with equity capital 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 because they don't have to pay it back, but it can be extraordinarily expensive and it can require massive amounts of work to grow an enterprise that's been funded this way.
Microsoft is an example of this type of operation, and it generates high enough returns to justify a pure equity capital structure.
This type of capital is money given as a loan to the business with the understanding that it must be paid back by a predetermined date. The owner of the capital—typically a bank, bondholders, or a wealthy individual—agrees to accept interest payments in exchange for you using their money.
Think of interest expense as the cost of “renting” the capital 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 to fund their operations.
The Small Business Administration administers numerous venture capital programs to small businesses, including long-term loans and loan guaranty programs to help small businesses obtain financing from other sources.
Debt can be the easiest way to expand for many young businesses because it's relatively easy to access and it's understood by the average American worker, thanks to widespread home ownership and the community-based nature of banks.
The profit for a business owner is the difference between the return on capital and the cost of capital. For example, a profit of 5% or $5,000 wouldn't have existed without the debt capital borrowed by the business if it borrowed $100,000 and paid 10% interest yet earned 15% after taxes.
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
Imagine you own a retail store. You need $1 million in capital to open a new location to expand your business. Most of that capital will be spent on buying or renting the property, product displays, cash registers, equipment, purchasing inventory to stock your shelves, and hiring new employees.
You open your doors and hope that customers come in and buy the items you're selling. In the meantime, your capital—either debt or equity capital or both—is tied up in the business in the form of inventory.
Now imagine that you could get your customers to pay you before you have to pay for your merchandise. This would allow you to carry far more merchandise than your capitalization structure would otherwise allow. This can be accomplished through vendor financing.
Dell Computer was famous for its nearly two or three-week negative cash conversion cycle which allowed it to grow from a college dorm product to the largest computer company in the world with little or no debt in less than a single generation.
An Example of Vendor Financing
AutoZone convinced its vendors to put their products on its shelves and retain ownership until the moment a customer walks to the front of one of AutoZone’s stores and pays for the goods. The vendor sells it to AutoZone at that precise moment, which in turn sells it to the customer.
This allows AutoZone locations 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. 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 typically be measured by looking at the percentage of inventories to accounts payable—the higher the percentage, the better—and analyzing the cash conversion cycle. In this case, more days “negative” is better.
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 those funds before paying benefits out to policyholders are in a very good place. They hold onto and use the money until a car is damaged, when a home is destroyed by a tornado, or when a business 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 exceptional cases, such as when you're paid to invest other people’s money and you get to keep the income from the investments.
Other types of businesses can develop forms of float, but it can be very difficult.
"Sweat equity" is accumulated when an owner and sometimes key employees bootstrap operations by putting in long hours at a low rate of pay per hour or for any pay at all. This makes up for the lack of capital necessary to hire sufficient employees 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 compensate the owner for the low-pay, long-hour sweat equity they infused into the enterprise.