Capital and How It's Used in Business and Economics
How Capital Keeps the U.S. Economy Humming
Financial capital is the money, credit, and other forms of funding that build wealth. Individuals use it to invest. They can make a down payment on a home, or create a portfolio for retirement.
It should not be confused with the capital that's one of the four factors of production that drive supply. That's capital goods, such as machinery, equipment, and tools. The other three factors are natural resources (the raw materials), labor (the number of employees), and entrepreneurship (the drive to profit from innovation). A market economy automatically provides these components of supply to meet demand from consumers.
Sometimes financial capital is called the fifth factor of production. That's not accurate. It facilitates production by providing income to the owners of production. But it is not itself a factor of production.
In business accounting, capital is how companies invest in their businesses. That means they can't use it now to give themselves raises, increase dividends, or lower prices. They must use it to produce greater gains in the future. A business uses capital to transform itself into something more profitable.
The word capital comes from the Latin capitalis meaning chief. It also comes from capit, maines captures and caput, meaning head.
Types of Business Capital
In business, there are three types of financial capital. The first is debt. Companies receive capital now that you pay back with interest. At first, many entrepreneurs borrow from family members or their credit cards. Once they have a track record, they can get bank loans and federal government assistance from the Small Business Administration. As these businesses continue to grow, they become large enough to issue individual bonds to investors. The advantage of debt is that owners don't have to share the profits.
The disadvantage is that they must repay the loan even if the business fails.
The second type of capital is equity. Investors give cash now for a share of the profits later. Most entrepreneurs use their own cash to get started. They put their own equity into the business in hopes of receiving 100 percent of the return later. If the company is profitable, they forgo spending some of the cash flow now, and instead invest it in the business.
Once a company becomes really large and successful, it can get additional capital from issuing stocks. This is called an initial public offering. It means any investor can purchase the company's stock.
The third type of capital is specialty capital. It's the extra cash flow that comes from managing the company's operations better. Vendor financing is when the company's suppliers are willing to accept delayed payment for their goods or services. Supply chain financing is like a pay-day loan for businesses. Banks lend the company the amount of an invoice (minus a fee), and accept payment when the invoice is paid. Company finance managers can also create extra capital through investing wisely.
How a company creates and manages its capital is known as its capital structure. Most public companies use a combination of debt, through bonds, and equity, through various types of stock. Many analysts use a simple formula, the debt-to-equity ratio, to determine how solid a company is. Companies with a ratio of 50 percent or more have more debt than equity. Analysts consider them to be highly leveraged and therefore riskier.
Easy access to capital has been one of the most important drivers of U.S. economic success. America has the world's most sophisticated financial markets. The transparency of the U.S. stock market allows investors to gain up-to-date information about every aspect of companies in which they might invest.
Wall Street attracts the most talented personnel and can afford the most powerful technology in the world. This allows U.S. banks to control billions of dollars in transactions that take place anywhere around the globe. It also enables these banks to provide any number of complicated derivatives to provide hedging against risk. This incredible comparative advantage supports a variety of complicated foreign exchange transactions at lower cost. (Sources: "Capital," Introductory Guide to Critical Theory, Purdue University, January 31, 2011.
"Is Social Capital Really Capital?" Review of Social Economy, November 2000.)