Define Capital In Simple Terms
Capital refers to money a company uses to finance growth.
The methods a company uses to raise capital is called its capital structure.
Businesses deal with four different types of capital in varying proportions.
Debt and equity capital are raised by selling securities.
- Debt capital: Debt capital is capital raised by taking on debt, usually by taking out a loan or issuing bonds. The cost of this form of capital depends on the cost of the interest payments, which in turn are dependent largely on the credit quality of the borrower.
- Equity capital: Equity capital is capital raised by issuing stock. Equity can be either public or private; public equity is raised in the open market by selling shares to investors, whereas private equity is financed by a pool of private investors. When investors buy company stocks they often come with voting rights, meaning investors have a say as to where the capital they invest goes.
Other Types of Capital
The other two types of capital, working and trading capital, are usually funded by a company’s cash flows.
1. Working Capital
Working capital is any liquid assets a company uses to finance day to day operations and short term debts, primarily cash and accounts receivable.
It is calculated on a regular basis by subtracting current liabilities from current assets (CurrAssets – CurrLiabilities) or by subtracting accounts payable from the sum of accounts receivable and inventory ((AccRec + Inv) – AccPay).
Trading capital is an amount of money allocated to buying and selling tradable securities.
Firms that do a significant amount of trading may have a fund of trading capital set aside to finance the buying and selling of marketable securities.
What Does Capital Mean In Finance?
Capital can also refer to capital assets, which are financially significant assets with a longer lifespan than one year that are intended to be used to generate profit through use rather than being sold.
The most common capital asset a company has is PP&E, or plants, property, and equipment.
Raising any type of capital comes at a cost. Buying new equipment requires spending cash, issuing debt necessitates interest payments, selling stock dilutes the value of stockholder shares, and so on.
In order for capital to successfully create wealth, it has to be deployed in a way that generates a greater return than the cost.
Investor Pro Tip
Many companies use a combination of methods to raise capital and finance operations.
The way that a company organizes this is called its capital structure.
Depending on the industry, certain methods of raising capital may be more or less common.
Big conglomerates that earn a consistently large income, such as General Electric, usually take on significant debts to pay for expansion.
However, because these companies earn such a large income, they can pay the debt back easily.
For smaller companies, such as start-ups, taking on debt is much more risky, and so equity financing is more common.
Companies may also change their capital structure in response to a change in business context.
For example, a small company that primarily relies on equity financing that is then acquired by a conglomerate might be switched to heavier debt financing by the new owners.