What Is Financial Capital?

How the Different Sources of Capital Keep the U.S. Humming

financial capital
The stock market provides a great deal of capital in the U.S. Photo: Mario Tama / Getty Images

Definition: Financial capital is the money, credit, and other forms of funding that companies use to 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. (Sources: "Capital," Introductory Guide to Critical Theory, Purdue University, January 31, 2011.

 "Is Social Capital Really Capital?" Review of Social Economy, November 2000.)

Capital is one of the four factors of production that drive supply. The other three 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.

Sources of Capital

There are three types of financial capital. The first is debt capital. This is where someone gives you cash now in return for a fixed return later. Many entrepreneurs use loans from family members or their credit cards to get started. Others may prefer to get bank loans and Federal government assistance from the Small Business Administration. They only need to pay back the interest, and eventually the principal. They don't have to share the profits (or losses). As these businesses continue to grow, they become large enough to issue individual bonds to investors.

These are essentially large loans.

The second type is equity. This is cash that is given now for a share of the profits later. Most entrepreneurs owners 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.

Others may get more funds from partners, venture capitalists, or angel investors. This often means they give up some control, and ownership, of the business in exchange for sharing the profits.

Once a company becomes really large and successful, it can get additional capital from issuing stocks. This is called an Initial Public Offering (IPO). It means the company's stock can be bought by any stock investor.

The third type of financial capital is specialty capital. This is 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.

Capital Structure

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.

Capital Markets

This easy access to capital has been one of the most important drivers of U.S. economic success. The U.S. has the world's most sophisticated stock market and financial sector. The transparency of our 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. This allows U.S. banks to control billions of dollars in transactions to take place anywhere in the world. 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.

For more, see Introduction to Financial Markets