Key Takeaways
- Financial capital is money, credit, and other forms of funding that build wealth for people and businesses.
- Businesses use financial capital to buy more equipment, buildings, or materials, which they use to make goods or provide services.
- There are three primary types of financial capital in the business world: debt, equity, and specialty capital.
- America's capital markets, which are the largest in the world, help fund 65% of the country's economic activity.
Definitions and Examples of Financial Capital
Financial capital is how companies invest in their businesses. They use capital to buy more equipment, buildings, or materials, which they then use to make goods or provide services. A business's capital assets can include cash and investments, as well. 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 firm produce greater future gains and grow profits.
How Does Financial Capital Work?
There are three main types of financial capital in the business world:
- Debt
- Equity
- Specialty
Each type sources funding differently, but all can help a business grow.
Debt Capital
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 firm 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 venture fails.
Note
The downside of using debt to raise capital is the interest expense.
Equity Capital
The second type of capital is equity, where the firm receivescash from investors now in exchange for a share of the profits later.
Most entrepreneursuse their own cash to get started. They put their own equity into the venture in hopes of getting 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 firm must give up some control in exchange for the cash from investors. Those investors become part owners of the firm.
Once a company becomes really large and successful, it can get more capital from issuing stocks. This is called an initial public offering. Itmeans any investor can purchase the company's stock. It's why stocks are also called equities.
3. Specialty Capital
The third type is specialty capital. Often, it 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 payday 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.
Note
With vendor financing, the firm's suppliers 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.
Capital Structure
The way in which a firm 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 to figure out how solid a firm is. This formula is called the debt-to-equity ratio. Companies with a ratio of 50%or more have more debt than equity. Analysts consider them to be highly leveragedand riskier.
Another component of the capital structure is working capital. It's the cash on hand needed to run the firm's operations. To find a company's working capital, the formula is current assets minus current liabilities.
Note
A working capital ratio of 2:1 means the company has enough liquidity to meet its present needs. If the ratio is higher, it means the company is not putting its money to use to build future profits.
Capital Markets
Easy access to capital enables U.S. businesses to innovate and expand. America has the world's largest capital markets. These fund 65% of the country'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 fourfactors of production that drive supply. In economics, capital includes durable goods such as machinery, equipment, and tools. These are used to create other products.
The other three factors of production are:
- Natural resources, which are raw materials
- Entrepreneurship or the drive to profit from innovation
- Labor, which refers to employees
Labor includeshuman capital, which is the skills and abilities of people.Social capitalis the value of a network of people.
In amarket 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 thefifth factor of production. But, that's not exactly accurate. Rather, financial capital makes production possible by providing income to the owners of production.
