We constantly see the term ‘capital’ throughout the business world. It appears in blogs, news articles, business plans, revenue sheets, and more. The term has broad usage and describes anything of benefit or value to an owner.
Many think of capital as cash only. But there are multiple classes of capital. For example, intellectual property is a form of capital for tech companies and publishers.
If you’re a small business owner, it’s important to understand ‘working capital’. It reflects the efficiency of your operation and shows how well you’re managing your cash flow and budget.
But other types of capital could also be important for your business. According to CB Insights, the top reason (38%) for small business death is the failure to raise new capital.
To help you stay out of that statistics category, this article explores capital in all its forms. We define the concept of capital, look at how to grow capital for your business, explore various types of capital, and break down capital gains and capital losses.
Table of contents
- Capital definition
- How to grow capital
- Capital gains and losses
- Bottom line
Capital definition
To define capital, we’ll look at the difference between capital and money and define it from economic, business, and accounting viewpoints.
What is the difference between capital and money?
Both physical and non-physical assets used in production — skills and education — make up capital. In any scenario, exchanging these assets requires money, so we measure capital in monetary terms.
Because businesses use money to purchase physical assets, the terms often become interchangeable. But capital and money are two separate entities. Capital has risk and ultimately creates jobs. Money can accumulate on a balance sheet with no risk or job creation.
Capital in economics
From an economic viewpoint, capital is necessary to keep a unit functioning, so it lives on both the short and long-term areas of a balance sheet. A unit can be an entire economy, a large corporation, a small business, or even a family. And
Assets considered capital include saleable securities like factories and equipment and cash and cash equivalents. It’s both a measurement of wealth and a resource people and businesses tap into to increase their wealth. For example, economists tie an individual’s net worth to the amount of capital and capital assets they hold.
Whether you’re a company or individual, how you finance working capital and invest obtained capital are critical to growth.
What is capital in a business?
Capital is one of the most essential elements for day-to-day operations and growth. Companies derive capital from business operations but can raise more capital by taking on more debt or by financing with equity.
From a budgeting standpoint, capital refers to cash or liquid assets held or accumulated for expenses. But it can also refer to a company’s other assets with value.
Overall, it’s anything a business can use to generate more value for the company. When businesses use capital to generate profit, these are capital gains. If a company’s total capital decreases but they use capital assets, it’s called a capital loss.
We examine capital gains and losses in detail below.
Capital in accounting
When an accountant or business owner looks at a balance sheet, capital refers to any company asset. This includes equipment, facilities, cash, and cash equivalents, like stocks, bonds, and other investments.
But the accounting mind breaks these various elements of capital into categories: working, equity, debt, and trading.
Working capital subtracts liabilities on the sheet, so it differs from the other types of capital. Debt capital must be paid back, so it isn’t really an accurate representation of a company’s assets.
Most accountants or business owners recognise working capital as most important as it’s the money a company has to work with after accounting for expenses.
We’ll explore all four types of capital in greater detail later on.
How to grow capital
Before examining how to grow capital, we must first look at what we mean by ‘growing’ capital.
Technically, looking at your balance sheets and making corrections to streamline and make a manufacturing process more efficient is a means of growing capital. Even bootstrapping a business during the initial phases can net capital growth.
But more commonly, capital growth refers to raising capital. This is when a business owner receives investment funds to facilitate either the launch, daily operations or growth of a business. The process can be burdensome for some owners, but most consider it a critical means of success.
Business owners can use either equity (dilutive) or debt (non-dilutive) financing to grow their available capital.
Capital growth methodologies
Before looking at the methods, understand that raising capital involves examining your balance sheets and understanding the reasons for choosing a specific methodology.
Everything will fall under equity or debt. It’s important to look at whether giving up some equity could help you reach your business goals. Or perhaps taking on some debt is a better situation because you’ll be able to pay the loan back in a reasonable amount of time.
Regardless, you can do it using one of the following methods.
Debt methods
Bond – useful for an established company; large pools of investors lend money.
Loan – company receives money from a bank or the government and pays it back with interest.
Credit line – it’s a credit card, and you’ll pay interest.
Equity methods
Venture capital – companies that invest money specifically to grow a company.
Angel/private investor – high-net-worth individual who invests money in exchange for equity in a business.
Initial Public Offering (IPO) – though this only works for established companies, it’s when you put your company on the stock exchange to raise capital.
Capital growth process
Whether you want to approach investors, lenders, or investment bankers, you need to plan thoroughly. People and/or businesses will commit money to your business based on its potential for growth, so you’ll need to show that your business will most likely succeed so they get a return on their investment (ROI).
The process can be long, but here are some steps you can take to ensure success.
Choose your funding strategy and determine what you want from your capital. Determine how much equity you’re willing to give up or how much debt your company can take on. Look at how high of an interest rate you can pay and still fulfil the plan.
Create a business plan that compiles everything you need to prove your business will be successful — documents, research, numbers, projections, etc.
Find investors through your personal network or other connections and set up as many meetings as possible. It’s a numbers game, after all.
Create and perfect a presentation — or pitch — that would make anyone want to invest in your business.
Follow up after your meetings to provide even more documentation or evidence.
Always negotiate and do your due diligence on the paperwork before fully closing your capital raise.
1. Working capital
Working capital makes up the available liquid capital assets a company has to fulfil its daily operations. To calculate this on a balance sheet, accountants use two assessments:
Subtracting a company’s Current Liabilities from its Current Assets
Adding the total Accounts Receivable and Inventory, and then subtracting the Accounts Payable
Look to the working capital on a company’s balance sheet for a measure of short-term liquidity. Businesses need enough working capital to pay their financial obligations and cover debts.
If a company is running a balance sheet with more liabilities than assets, this will quickly become a problem.
2. Debt capital
Debt capital describes capital obtained by borrowing from public or private funds. Companies with an established credit history typically borrow from financial institutions or issue bonds. Smaller, newer companies often borrow from personal contacts, credit card companies, online lenders, and government loan programs.
Credit history and debt-to-capital ratio
You’ll need a credit history to borrow funds, and you’ll have to repay the loan with varying interest rates based on that history and the amount of money you want to borrow.
Debt is a burden to the lender and an opportunity for the lendee, but loans cannot support a business — especially if you don’t pay them back. This method is often the only way businesses have access to sizable sums of money at one time. It’s important for both parties to examine the businesses’ debt-to-capital ratio in this scenario.
As mentioned, a company can also issue bonds to raise debt capital. Businesses typically go down this route when overall interest rates are low, so they don’t have to pay back as much money.
3. Equity capital
Companies obtain equity capital in various formats, including public, private, and real estate.
Public and private equity
In the public and private equity forms, investors gain shares of the company in return for their investment. Private equity capital is one of the most popular forms of startup capital through venture capitalists, VC firms, and/or angel investors.
Public equity capital involves selling shares of the company on a public stock market. This form of equity raise is expensive and typically reserved for established companies. But an initial public offering (IPO) is one of the most notable and valuable ways to raise capital.
Real estate equity
For real estate equity capital, a lender lets a company conduct business on their property for shares of the company. The business can either purchase the building at a later date or move to another location based on the terms of the agreement.
4. Trading capital
We use the term trading capital with businesses that operate in the financial industry. This term denotes the amount of money a firm or individual has to buy and sell securities.
These businesses use trade optimisation methods to increase their trading capital. The key to their business is to optimise the cash reserve needed to carry out their investment strategies.
When you think of trading capital, think of a large brokerage firm like J.P. Morgan, Fidelity Investments, and Vanguard. Each of these firms allocate a specific amount of trading capital for financial professionals to make trades.
Capital gains and losses
To round off our overview of capital, let’s examine capital gains and capital losses.
Capital gains
Capital gains occur when businesses sell capital assets for more money than they originally paid. This can include any of the asset types listed above, including stocks, bonds, real estate, manufacturing items, etc.
When a business holds a capital asset for over 12 months and sells it, this is known as a long-term gain. And anything less than 12 months is a short-term gain. We’ll go into more detail in the capital losses section, but know that there are tax implications based on whether a capital gain is long or short-term.
On a balance sheet, subtract the purchase price from the sale price to get your capital gains.
Capital gain example
Imagine a business purchases an excess amount of manufacturing equipment for an expected increase in production. But the increase never happens. So the company sells off the extra equipment.
Fortunately, when the business sells the equipment, they can make a profit on the sale. That profit is capital gain.
Capital losses
Capital loss is exactly the opposite of captain gain. A capital loss occurs when a business sells a capital asset for less than they originally paid. Again, this includes all asset types reviewed in the article.
The government taxes specific types of capital gains, and companies use capital losses to offset the full tax burden. Corporations submit these numbers quarterly and usually pay a tax on their capital gains at the end of their fiscal year.
There's no capital gains tax when a company’s capital losses are higher than its capital gains. But in this situation, the company can carry the capital losses forward to an upcoming tax year and deduct them from the future capital gains.
Capital loss example
Let’s say a company purchases a warehouse and wants to sell it five years later to upgrade to a larger one. Unfortunately, the property value for their original warehouse decreased over the past five years, and they have to sell it for 10% less than what they paid. It’s the price of doing business.
The 10% loss on the warehouse sale is a capital loss.
Bottom line
The term ‘capital’ has many uses, so it comes down to context. Typically, capital refers to the money on a company's balance sheet available for operations or expansion.
This capital could be equity capital, debt capital, or working capital based on how the company acquired the funds and how they intend to use them. And for a financial firm, that can include trading capital.
When determining capital assets, businesses and accountants include everything of value, including real estate, equipment, and cash. But economists look at capital within a larger frame and include all the money in circulation.
