Financial Capital, Its Types, and Its Critical Role in the Economy
How Capital Is Used in Business and Economics
Financial capital is the money, credit, and other forms of funding that build wealth. Individuals use financial capital to invest, by making a down payment on a home, or creating a portfolio for retirement. Businesses use capital to increase revenue.
Capital in Business
In business accounting, capital is how companies invest in their businesses. They use financial capital to buy more equipment, buildings, or materials, then use them to make goods or provide services. A business's capital assets can include cash and investments in addition to equipment or facilities, and these assets are listed on its balance sheet.
Managers can't use the money to give themselves raises, increase dividends, or lower prices; they must use it to help the company produce greater future gains and grow more profitable.
Types of Business Capital
There are three primary types of financial capital in the business world:
Each type sources funding differently, but all can help a business grow.
The first type is debt. Companies receive capital now that they 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.
Once a business grows large enough, it can raise money by issuing 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 downside of using debt to raise capital is the interest expense associated with it.
The second type of capital is equity, where the business receives cash from investors now in exchange 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% 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.
Another way to get equity is from partners, venture capitalists, or angel investors. With this method, a business must typically give up some control and ownership of the business in exchange for the cash from investors.
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—and it's why stocks are also referred to as equities.
The third type of capital is specialty capital. Often, specialty capital is a way of buying time to grow revenue, for instance by delaying invoices.
A popular form of specialty capital is supply chain financing. It's like a pay-day loan for businesses. Banks lend the company the amount of an invoice, minus a fee. They receive payment for the loan when the invoice is paid.
Vendor financing is when the company's suppliers are willing to accept delayed payment for their goods or services. This is also sometimes called "trade credit." A vendor may require shares in the company as collateral.
Company finance managers can also create extra capital by investing in the stock market.
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% or more have more debt than equity. Analysts consider them to be highly leveraged and therefore riskier.
Another component of the capital structure is working capital. It's the cash on hand needed to run the company's operations. To find a company's working capital, the formula is current assets minus current liabilities.
The working capital ratio is current assets divided by current liabilities. A working capital ratio of 2:1 means the company has enough liquidity to meet its immediate needs. If the ratio is higher, it means the company is not putting its money to use to build future profits.
Easy access to capital enables American businesses to innovate and expand. America has the world's largest and most sophisticated capital markets, which fund 65% of America's economic activity.
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.
The U.S. bond market is 1.9 times larger than the next largest fixed-income market, which belongs to the European Union. The investment banks servicing this market underwrite the bonds and guarantee their success.
Financial Capital vs. Capital in Economics
Financial capital should not be confused with the economics term capital, meaning one of the four factors of production that drive supply. In economics, capital includes durable goods such as machinery, equipment, and tools which are used to create other products.
The other three factors of production are:
- Natural resources, which are the raw materials.
- Entrepreneurship, or the drive to profit from innovation.
- Labor, which refers to employees. Labor includes human capital, which is the skills and abilities of people. Social capital is the value of a network of people.
In a market economy, in which the laws of supply and demand direct production, these components of supply are used to meet consumer demand.
Sometimes financial capital is called the fifth factor of production, although that's not exactly accurate. Rather, financial capital makes production possible by providing income to the owners of production.