In broad terms, capital describes anything that gathers benefit or value to the owner. This can include factories, machinery, or financial assets. Also, capital usually has to do with the cash that individuals and firms put to work for investment and productive purposes.
This is a critical aspect of running a business daily and financing its future growth. It refers to all man-made productive assets, that is all man-made wealth or goods used in making other goods and services. We can also refer to them as investment goods or producer goods. They are goods that do not give direct satisfaction but assist in the production of consumer goods, services, and other capital goods. Business capitals can be derived from business operations, debt financing or equity financing.
The way businesses and individuals finance their working capital and invest that which they have obtained is relevant for their prosperity.
Generally, capital can be a mechanism for measuring wealth and as well a resource for increasing wealth. Increasing wealth can take place through direct investment or capital project investments. Individuals hold capital as part of their net value and companies have structures that include debt, equity, and working capital for their daily expenses. It is typically cash or liquid assets that companies hold or obtain for running expenses.
Table of Contents
- What is the capital?
- Uses and importance of capital
- Types of Capital
- The characteristics or features of capital
- Capital vs. Money vs. Wealth
- Capital Investment
- Capital accumulation (formation)
What is the capital?
Capital is a passive factor because, without human efforts, they will not be useful in themselves. The reward that accrues to capital is called interest.
Capital in economics
Capital in Economics consists of assets that humans created that can enhance one’s ability to perform work that is useful to the economy. From the economist’s point of view, it is key to the functioning of any unit, be it family, a small business, a large corporation, or an economy at large. They are as well looking at cash circulation within an economy.
Capital in finance
In finance, the term refers to cash or liquid assets that a business firm holds or obtains for expenditures. In broad terms, we can say that it includes all of a company’s assets that have a monetary value. These assets include a company’s equipment, real estate, and inventory. When it comes to budgeting, the term refers to cash flow.
Capital in business
Capital in business is the money that is available for the day-to-day running of the operations of the business and its expansion in the future. The profits or revenue of a business constitute the sources of its capital. Generally, we use capital assets in a broader term.
We can find capital assets on either the current or the long-term part of the balance sheet in accounting. These assets include cash, cash equivalents, and marketable shares/securities. Manufacturing equipment, production facilities, and storage facilities form part of these assets.
Uses and importance of capital
Companies use capital to pay for the ongoing production of goods and services to create profit.
Companies use their productive assets to invest in all kinds of things for the purpose of creating value. Labor and building expansions are two common areas of capital allocation. A business or individual seeks to earn higher returns by investing capital turn by investing capital than the capital’s costs.
At the global and national levels, economists analyze financial capital to understand how it influences economic growth. Economists watch capital metrics, capital including personal income and personal consumption from the Commerce Department’s Personal Income and Outlays reports. We can also find it in the quarterly gross domestic product report.
It facilitates massive production of goods and services, for example, the use of machines increases the output of goods and services. Also, it allows work to take place, works that could have been impossible as well as increasing the quantity of work done per time.
With the availability of capital, it is easier to improve the quality of products by easing higher standards of accuracy. As we have seen above, it contributes greatly to the smooth running of any business enterprise.
Types of Capital
Different scholars classified capital differently. Some classified into three major types, some classified into four basic types, while some classified into five types. We shall look at the three different classifications.
The three (3) types of capital (forms of)
This has to do with the long-term producer goods of a firm. In other words, it refers to the durable investments that require renewal only at slightly longer intervals. It does not change its form in the process of production and it includes factory building, machinery, tools, and office equipment.
b) Circulating or working capital
This has to do with the goods that either change their form or even used up in the process of production, while some change to finished goods. Companies require most forms of working capital on regular basis to maintain production. It includes raw materials, stock of semi-finished goods, fuel, money set aside for the payment of salaries and wages, and debts owed to the company by consumers.
This has to do with the capital goods collectively owned, that is the social infrastructure. Some consist of the social assets of a nation or a community such as roads, schools, hospitals, electricity, water supply, etc. It is important to understand that not all social wealth is social capital. It is only those social wealth that aid production that we regard as social capital.
We should also understand that some of these social assets may not directly connect to production. They however help to improve the efficiency of labor and as well raise the standard of living. For example, if a worker is healthy, well educated, and properly housed, he will be able to work more efficiently.
The four (4) types of capital
A business can obtain capital through borrowing (debt) and they are obtainable through government or private sources. For companies that are well established, it is the most common means of borrowing from banks and other financial institutions or the issuance of bonds. For a small-scale business that is just starting, they may source it from friends, families, online lenders, federal loan programs, and credit card companies.
Just like individuals, businesses need to have an active credit history to be able to borrow. It requires regular repayment with interest.
Individuals most times see debts as a burden while businesses look at it as an opportunity if the debt does not get out of hand. It is usually the only way most businesses are able to obtain a large, sufficient lump sum to pay for major investments in the future. It is necessary for both businesses and their potential investors to keep an eagle eye on the debt to capital ratio to avoid getting too deep into it.
It can come in different forms such as private equity, public equity, and real estate equity. Private and public equities can come in the form of shares of stock in the company. The only difference is that public equity comes by listing the company’s shares on the stock exchange while private equity comes from among a closed group of investors.
An individual investor is providing equity to the company when he buys shares of stock.
c) Working Capital
We can calculate it in the following ways;
Working capital = Current Assets – Current Liabilities
Working capital = Accounts Receivable + Inventory – Accounts Payable
It measures the company’s short-term liquidity, that is the company’s ability to cover its debts, bills payable, and other obligations due within a year.
We can also define it as current assets minus current liabilities. When a company has more liabilities than assets, it will definitely run out of working capital.
Every business needs a sufficient amount of capital in order to operate effectively and generate profitable returns. Balance sheet analysis is important to the review and assessment of business capital because it shows the statement of financial position.
Investors may make attempts in adding to their trading capital by adopting different trade optimization methods. These methods try to make the best use of capital by determining the best possible percentage of funds to invest with each trade.
It is important for traders to determine the optimal cash reserves required for their investment strategies to be successful.
Five types of capital
The subject matter most commonly refers to the financial assets a company needs to provide goods or services. We measure it in terms of monetary value.
We can define it as the earth’s stocks of natural assets that include geology, soil, air, water, and all living things. It is from these resources that humans derive a wide range of services and we often call them ecosystem services, that make human life possible.
This has to do with the stock of habits, knowledge, social and personality features (including creativity) that form part of the ability to perform labor in order to produce economic value. It is unique and is distinct from every other capital. Companies need it to achieve objectives, develop, and remain innovative.
This consists of physical assets generated by applying human productive activities to natural capital and efficient to provide further goods or services. It is the productive capacities of an individual. These capacities can be both inherited and acquired through education and training.
The characteristics or features of capital
It is not a gift of nature, also, it is not a primary or natural factor, it is man-made in the capital goods industry. It is a secondary as well as an artificial factor of production. Human effort makes it useful, that is, without human efforts, it is almost useless or dormant.
It helps in increasing the level of production as well as giving more speed to production. Also, it is not a consumer good. In other words, it is meant for the production of further goods.
The supply of capital depends upon the process of capital formation as well as capital formation depends on savings and investment. By improving its formation or accumulation, the supply can be increased though it is a long-term process. It there possesses an elastic supply.
Capital is not perishable like labor, it has a long life subject to depreciation over a period of time.
The movement of capital from one place to another is easily possible. in other words, we can move these resources from one place to another for production purposes.
Since capital has all features of wealth such as utility, scarcity, transferability and externality, capital is wealth but not all wealth is capital.
As a factor of production, it has a derived demand to produce finished goods which have a direct demand. e.g. demand for raw cotton is derived from the demand for cotton cloth.
These goods don’t satisfy our wants directly but companies should resources should divert them towards the production of goods that will assist further production first. Thereafter they can use such produced to produce consumer goods having direct demand.
Resources have alternative uses, we can either put them to the production of capital goods or consumer goods. When companies use resources for the production of capital goods, it implies that society has sacrificed the enjoyment of consumer goods and we refer to it as a social cost.
Capital vs. Money vs. Wealth
Generally, capital is money. For the purpose of finance and business, we view the term from the viewpoint of current operations and investments in the future. It usually comes with a cost. Like in the case of debt, its cost is the interest required during repayment. For equity, the cost is the distribution the company makes to shareholders. Generally, the deployment of capital is meant to help shape a company’s growth and development.
Many capital assets are not liquid, that is, they are not readily convertible to cash in order to meet immediate needs.
A company that summed up its capital value would include every item that the business owns as well as all of its financial assets and then subtracting its liabilities. An accountant who handles the day-to-day budget of a company will only consider only its cash in hand as its capital.
In relating the term to wealth, every capital is wealth, that is capital is a type of business wealth. However, not all wealth is capital. This is simply because some forms of wealth do not assist in the production of further goods/products. Examples of personal wealth include personal cars, clothes, and jewelry. These things do not assist direct production and most times they do not assist further production.
This has to do with the company procuring money in order to further the goals and objectives of a business. The term also refers to a company acquiring long-term assets such as real estate, manufacturing plants, and machinery. We can also say that it is the sum of cash a company acquires to pursue its goals and objectives which include continuing or growing operations.
A company can acquire cash from many sources which include the sales of assets and the issuance of debt or equity.
This is meant to benefit a company in the long run though it can have short-term disadvantages. Usually, companies make these investments to increase their operational capacity, capture a larger share of the market, and generate more revenue. A company may make these investments in the form of an equity stake in another company’s complementary operations for the same purposes.
One of the disadvantages of capital investment is that its first funding option is usually a company’s own cash flow and it may not be enough to cover some anticipated costs. the company is more likely to resort to external financing in order to make up for any internal deficiency.
Capital accumulation (formation)
This involves increasing the stock that is needful for further production. It usually depends on savings. Saving involves forgoing or sacrificing some present consumptions in order to accumulate capital. In this case, one has to do without some consumer goods. This is the reason why capital formation or accumulation involves waiting.
A country’s production wealth at any given period is a result of the sacrifices the citizens made in the past. People can achieve any further increase in stock by foregoing some present wants, particularly consumer goods.
The production or increment of capital goods for the purpose of production is known as investment. Investment highly depends on saving since one can only invest the amount he has saved.
In every county, in the early stages, the rate of forming productive resources is usually slow. Once some of these resources have been formed, this can assist in further accumulation. The provision of capital in developing countries usually plays a vital role in speeding up economic development.
In developed countries like the United States and Japan, productive stocks are high and there are high rates of capital formation. In developing or underdeveloped countries, the reverse is usually the case.
How to accumulate capital
Countries can increase the available productive stocks available for investment by depending on foreign resources in the form of grants, aids, and loans. Loans are usually preferable since obtaining grants and aids from developed usually have lots of strings attached. That is, the donating countries usually attach countries that may benefit them and these conditions tend to be quite expensive to the recipient country.
They can raise loans from financial institutions such as the world bank or the international monetary fund. When countries use these loans efficiently, they will yield more productive results.
Saving money for investment
We said earlier that capital formation depends on saving. Companies can use the money they saved to purchase goods for further production.
It is important for governments to encourage saving and this can happen in different ways. They can remind citizens to save through mass media advertisement, give incentives and encourage the establishment of banks in rural areas, and encourage the use of mobile banking.
Individuals can save by cutting down the amount they spend on consumer goods such as luxuries and involving in less unnecessary spending. They can channel the money they saved towards investment.
More investment in the productive ventures
The government should spend less on non-productive ventures and invest directly in the productive sectors of the economy. They can set up government-owned enterprises or venture into joint ownership with private individuals. In this case, the government can own more shares thereby helping to provide sufficient capital for investment purposes.
The government can encourage commercial banks to give out loans to borrowers that are ready to invest in productive ventures. Governments van set up institutions that provide loan facilities for investors.
Progressive taxation system
Progressive taxation is a system of taxation in which the government levies higher tax rates on the high-income earners and lower tax rates on the low-income earners. When the government places high taxation on the rich, it will reduce their disposable income thereby reducing the amount they spend on non-productive projects. More money will be available to the government which they can channel into productive ventures.
Greater use of plough back profits
Business firms can invest part of their profits rather than sharing everything with the owners who may spend them on consumer goods. This is a form of saving for investment and it helps in the formation. The government can encourage this by reducing the taxes of companies in order to increase retained earnings of enterprises.
Production of more goods
Companies can accumulate capital by producing more productive goods. They can cut down the time and resources they use in producing consumer goods. this will increase the number of resources they use to produce capital goods. They can as well reduce their leisure time and devote more time to the production of capital goods.
Companies/producers can sell more of their products and use the money to buy more goods that aid in further production.
It is important to know that any man-made resource that aids in further production refers to capital. They are made with the sole aim of helping man to produce further goods.
For example, the purpose of manufacturing a printing machine is to use it to make/print books. Also, factory buildings, machines, tractors, typewriters, and sewing machines are all capital goods. This is because they aid in the production of further goods.
Financial capital is the money, credit, and other types of funding that constitute wealth. Individuals use financial capital to invest, by making a down payment on a home, or creating investments for retirement. Because money can purchase other productive goods, we also regard it as capital which is the accountant’s point of view.
We looked at the meaning of the term from different points of view such as its meaning in economics, business, finance, and accounting. It is important in the smooth running of a company as well as the economy. This is because it is a mechanism for measuring wealth and a resource for increasing the wealth of a firm and that of the entire economy.
We also looked at the types of capital which include fixed, circulating, social, equity, debt, and trading capital.
Capital is relevant in facilitating the mass production and distribution of goods and services as well as improving the quality of products.
Chyou is a published author who focuses on the field of international business. After an established career facilitating mergers and acquisitions for medium to large corporations, Chyou turned to writing to help students better understand international business concepts.