What is Capital in Business?
Capital is both the assets and financial resources owned by a business to promote its growth and help generate revenue. Generally, capital in business is a term used to describe anything that helps generate value for a company. For instance, a storage facility owned by a company or the tangible machinery it uses to create a product is categorised as capital. However, raw materials used in the manufacturing processes are not measured as capital.
What is the purpose of capital?
Capital provides the necessary tools to undertake business activities and develop and improve the future of the business. The business activities should be valuable and allow for the generation of sustainable revenue in the long term.
Capital is a core concept in business and requirements for capital vary from business to business. However, without capital businesses would not be able to fund their operations and generate revenue.
There are three main types of capital – financial, human, and natural. The most common forms of capital in business are human and financial.
Financial capital is an asset with the monetary value used to create further revenue. Working capital, equity capital, and debt capital all fall within the financial capital category. Trading capital also falls within this area, but it is typically only used within financial institutions.
Working capital is the measure of a company’s liquidity. In general terms, it is the total amount of capital invested into a company’s day-to-day operating activities. To calculate working capital, you must identify the difference between operating current assets and operating current liabilities. By managing working capital well, a company can improve its cash flow and increase its return on assets (ROA).
Equity capital represents the core funding of many businesses. Equity capital refers to the sale of common or preferred stocks to investors in exchange for the investors paying into the business. However, investors may then have a level of control over a section of the business it funds.
Debt capital is the capital raised as a result of a business borrowing from a lender. For example, a loan is typically taken out by a business in order to grow capital and this is then later repaid. Debt capital is different to equity because the lender will not become shareholders in the business. Instead, the lenders are considered creditors that will typically receive interest as the loan is repaid. If an entrepreneur funds their own business it would still be classed as debt capital because the business is borrowing money from its owner.
Trading capital is the amount of money generated by a company after selling or buying various assets.
Human capital is an intangible financial value that refers to the knowledge, training or skills of an employee. Within the human capital theory is social, talent, physical and intellectual capital. Human capital can yield a flow of services for a business and they can be improved through education and training.
Natural capital refers to natural assets provided through the environment and ecosystem such as air and water. There are varying forms of natural capital, including animals, vegetation and ecologies.
How is capital different to money?
Money is often referred to as capital. However, they are two very different business concepts. While money is used to buy and exchange goods and services, capital is instead viewed as means of product, resources, or investment for the future. Capital is often referred to as the money or cash used for investment or productive business purposes. It is easy to mistake capital for money, this is due to capital being measured in monetary terms. For instance, the value of a physical asset such as a factory.
Capital structures of a business
A capital structure is a combination of a business’s debt and equity provided to enable it to operate over a long-term basis. The capital mix can include share capital such as common stock or preferred stock along with a company’s long-term debt or short-term debt, such as bank loans.
When identifying a company’s capital structure, you will consider the proportions of finance which are debts compared to those that are equity. There are advantages and disadvantages to both high equity and low debt capital structure versus low equity and high debt capital structure.
Debt can be relatively cheap to finance when the interest rates are low. If profits and cash flows maintain strong then the debt can be paid back easily.
However, debt can be considered high risk for start-up companies or those who do not have high-profit margins. Therefore, those businesses may opt for a higher equity capital structure. The benefits of this include more flexibility in which a firm is not required to pay dividends. Equity capital also has no maturity date, so businesses have no responsibility to redeem equity shares.
What is ‘Cost of Capital’?
For investors, the cost of capital is the amount of return an investment must make to provide the next venture. The amount varies depending on the type of investment, how long they lend the money for, the fees needed to make the deal happen, and how likely they are to get the money back.
For businesses, the cost of capital metric – which is the weighted average of a company’s cost of debt and cost of equity – is used to budget for a capital project, such as purchasing a new piece of machinery.
The weighted average cost of capital (WACC) calculates a business’s overall cost of capital for all its sources of capital, such as long-term debt, preferred stock, common stock or bonds. The WAAC is calculated by multiplying debt and equity by its market value. You then add the products together to calculate the total.
The cost of capital is used by businesses and investors to identify whether an investment or capital budgeting project is worth the risk. The cost of capital will identify the minimum rate of return needed to make an investment or capital budgeting project worthwhile. By identifying a minimum rate of return, businesses will be aware of the level at which the asset or investment must reach to generate a profit. A business’s cost of capital depends primarily on its capital structure and how it chooses to be financed. Different companies will have different capital structures.
How does financial capital differ from capital goods?
Capital goods, sometimes referred to as durable goods or economic capital, are the physical assets used by a company. Capital goods are used by companies to produce their goods and services which will later be sold to consumers. Capital goods differ from financial capital in that financial capital is used to grow revenue. Common forms of capital goods are fixed assets such as buildings and machinery.
Is capital taxed?
Capital owned by a business is protected from tax costs. However, this does not completely rule out tax. Capital that is sold or transferred can face tax costs. In the UK this is referred to as capital gains tax. This is a tax on the profit when you sell something that has increased in value. You will be taxed only for the gain or profit you make, rather than the money you receive from the sale. A capital gain is when the capital has increased in value from the time of purchase to the time of sale. If the gain made falls within your tax-free allowance, you will not be required to pay capital gains tax. The money generated from capital gains tax should go to the public benefit.
Also, businesses will need to consider capital losses and calculate their net-taxable gains for the tax year. Capital losses refer to the loss a company faces when its asset depreciates in value. This will automatically be offset against capital gains and reduce taxable income.
What is Capital in Business Summary:
- Capital in business is the value of assets available to fund a firm’s day-to-day operations and fund its growth. Some examples of business capital include the use of production equipment, machinery, or warehouses.
- Capital is calculated through both tangible and intangible assets. Examples of tangible, or physical, assets include equipment and buildings. Whereas intangible assets are not physical and include intellectual property such as patents.
- In order to develop short term financial stability, businesses should strive to have a high level of capital available.
- Working capital is used to pay expenses including payroll and other business operation costs.
- Capital expenditure is often made by companies to benefit their operations. The term refers to money spent by a business to obtain assets such as land, buildings or technology.
- Capital assets are items owned by businesses or organisations for the purposes of investments. Examples of capital assets include property or office equipment.
- Capital investment is the act of acquiring a sum of cash in order to reach its business goals and objectives.
- Venture capital is a form of investment for entrepreneurs and start-up companies. It differs from private equity in that venture capital invests in new companies.
- You may also hear the term capital used by economists. Capital, which may also be referred to as liquid assets by economists, is often used as a global indicator of economic growth.
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