What is Capital in Business and Why Does it Matter?

Capital is a critical component of running any successful business At its core, capital refers to the money and assets a business has available to fund its operations, investments, and growth But not all capital is created equal – there are important distinctions between different types of capital that business leaders need to understand. In this comprehensive guide, we’ll examine the key concepts, categories, and structures of business capital so you can leverage this resource effectively.

What is Capital?

In simple terms, capital is money. But in business and economics it refers specifically to the financial assets companies use to fund growth and generate value.

Capital can be classified into two major categories

• Financial capital – This includes economic resources like cash, funds held in checking/savings accounts, lines of credit, and liquid investments. Financial capital is used to run day-to-day operations and make investments.

• Physical capital – Physical assets like machinery, facilities, equipment, and real estate. Physical capital represents concrete resources a company owns.

Beyond those broad categories, there are several more specific types of capital used in business:

• Equity – Funds raised by selling shares or stock in a company. Equity doesn’t need to be repaid like debt.

• Debt – Money borrowed that must be repaid over time, often with interest. Sources include loans, bonds, and lines of credit.

• Working capital – Liquid assets available to cover short-term operating costs and immediate obligations. Calculated as current assets minus current liabilities.

• Investment capital – Funds dedicated specifically to making investments in assets, equipment, property, etc. aimed at growing the business.

• Human capital – The skills, knowledge, and experience possessed by a company’s workforce that help it succeed.

• Intellectual capital – Intangible assets like patents, trademarks, copyrights, and proprietary methods that provide a competitive advantage.

• Social capital – The network of relationships and connections an organization cultivates to access resources and opportunities.

Why is Capital Important for Businesses?

Access to capital is one of the most fundamental requirements for starting and expanding a business. Here are some of the key reasons capital matters:

• Funding growth – Raising capital is necessary for funding investments in new locations, products, hiring, acquisitions, R&D, and entering new markets. These long-term investments are critical for business growth.

• Managing expenses – Revenue rarely aligns perfectly with expenses. Working capital ensures companies have cash available to cover payroll, supplies, taxes, and other short-term costs.

• Stability – Maintaining reserves of capital provides resilience against unexpected expenses or temporary revenue declines.

• Opportunity – Readily available capital means companies can quickly seize promising opportunities and adapt to changing conditions. Slow access to capital causes missed opportunities.

• Creditworthiness – Lenders and investors view the amount of capital a business has as an indication of its financial health and ability to repay debts. More capital means increased credibility and better loan/financing terms.

Clearly, capital and access to it is a major determinant of success and growth for any business.

Major Sources of Capital for Businesses

When starting and expanding a company, where does the capital come from? Here are some of the major sources:

• Personal Investment – Many entrepreneurs self-fund at least a portion of their business initially, often by tapping into personal savings, home equity, or assets.

• Business Operations – Reinvesting revenues from ongoing operations back into the business is a simple way to build capital reserves over time. However profitable business models generate capital more quickly.

• Investors – Angel investors and venture capitalists provide an influx of capital to startups and emerging companies in exchange for equity stakes.

• Crowdfunding – Raising smaller amounts of capital from a large pool of individuals, often in exchange for future products or equity.

• Bank Loans – The most common way to access debt financing is through bank loans. This provides capital that must be repaid with interest over time.

• Bonds – Larger, more established companies can raise debt capital by issuing bonds purchased by institutional investors.

• Government Programs – Federal, state, and local programs exist to provide grants, loans, and other funding to small businesses and entrepreneurs.

• Financial Institutions – Specialty finance companies and non-bank lenders offer alternative lending options including short-term loans and merchant cash advances.

• Partners – Strategic partnerships can provide capital injections from larger corporations in exchange for distribution rights, equity, etc.

Capital Structure and Management

Capital structure refers to the mix of equity and debt capital used to finance a company’s assets and operations. The proportions of equity vs. debt has implications for risk, cost, control, and flexibility. The optimal structure depends on factors like industry, size, profitability, credit profile, and more.

Most established companies aim to maintain a balanced capital structure using a combination of equity raised from investors and shareholders, and debt financing from bank loans and bonds. The following metrics help evaluate capital structure:

• Debt-to-Equity (D/E) Ratio – Compares a company’s total debt to total shareholders’ equity. Higher means more leverage and risk.

• Debt-to-Capital Ratio – Debt as a percentage of total capital (debt + equity). Higher indicates more leverage.

• Weighted Average Cost of Capital (WACC) – The blended average cost of raising funds from equity and debt sources, weighted by usage. Lower WACC is better.

Proper capital management is crucial. Companies must continuously monitor their capital inflows and outflows, and adjust their capital structure over time to optimize for growth, risk, and financing costs.

Maintaining adequate capital reserves provides stability and flexibility, while retaining access to capital allows a business to quickly act on opportunities when they arise. For these reasons, both startups and mature companies need to devote significant focus to strategically managing their capital.

Capital encompasses the financial assets companies employ to fund operations and growth. While there are various types of capital, from working capital to support daily needs to investment capital for major projects, the unifying thread is that access to capital is essential at all stages of the business lifecycle.

By understanding the role capital plays, diverse sources it can come from, optimal capital structure frameworks, and best practices for ongoing capital management, business leaders can ensure this critical resource is leveraged to maximize growth and success.