Which capital?
Capital is important isn’t it? “Of course”, l can imagine you saying so! But do you really know which type of capital l am referring to here? Is it the capital city of a country/region or capital as in a financial asset?
Well, you don’t need to stress yourself guessing because that is exactly what l am going to explain in this edition - to help you understand the basics of capital as a financial asset.
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In broad terms, capital is often used to refer to a sum of money, often large enough to become the seed money for a business.
It could be the money used to start a business or the additional funds introduced into the business to help it grow or survive. That is why sometimes you hear of words like “minimum capital requirement”, “stated capital” and so on.
These terminologies are used to refer to some form of funds (money) or quantifiable assets in a business.
In the banking industry, again as an example, the capital requirements for the various sub-sectors are clearly defined, together with all the other requirements needed before anyone is allowed to operate a business as a deposit-taking or non-deposit taking licensed institution.
Let me quickly introduce the point that it is not always the case that capital must be in hard cash. Sometimes, the buildings and other machinery which are necessary and could be usefully employed in the production of goods and services qualify as capital.
This makes sense because, after all, you still need to spend money to acquire those assets. Insofar as its use in the fulfillment of a regulated capital requirement does not distort the capped proportion of cash and asset combination, it should be allowed.
Of course barring any other problems, such as your inability to prove the source of capital.
Regulators of some industries (securities, banking, insurance etc.) always make sure that the regulated institutions have the adequate capital buffer that could help them to withstand unexpected shocks - and even anticipated ones, such as provisions for losses (losses that are anticipated to occur but the exact amount cannot be calculated with certainty).
Accountants love capital too! In their assessment of the going concern status of a company, be they manufacturing or services entities, accountants, and by extension auditors, would want to know whether the company has the right net worth to guarantee that no significant part of its operations would be curtailed in the foreseeable future due to capital constraints.
After all, capital is the only guarantee against losses in bad times. The strong link often established in some sectors is the extent to which the capital erosion or its impaired position could impact on liquidity, and further deterioration leading to insolvency.
Overall, these different forms of capital are all financial in nature, with some serving as pure cash, near cash and other quantifiable assets.
With that explanation given, let us look at what capital could mean in other fields also, and some of the instruments that could be used to raise capital to finance an enterprise.
In economics literature, you may also find discussions on economic capital, often used in reference to the estimated amount of money needed to cover possible losses from unexpected risk.
This measure can be used as a solvency marker also. When an asset is “economically useful”, that is, it can enhance the performance of a task, that “asset” is capital.
Let me add that the capital story is not that simple at all times. The concept has evolved and engineered, in tandem with business evolution.
Some decades back, capital was straightforward. If you needed money to start a business, for example, you can use your own savings, rely on friends and family to help, or present a compelling business case to a bank for a loan. You bear the risk alone when you go on this route.
However, today, you can use established formal channels like the Stock Exchange to raise equity financing as capital for your business. With this approach, you actually give part of the company to the “investor” to own, and this will be based on the agreed valuation of the business enterprise.
Compared to loans (debt), equity capital is more patient in the sense that the company (or you) is not committed to making any agreed regular payments to the investor as interest on the amount raised.
The investor bears part of the risk of the business, and is highly motivated by equity appreciation (growth), and income in the form of dividend, whenever the business makes money and declares such payments to shareholders.
With debt capital, the commitment could be a straight, agreed interest on the invested amount by the investor, irrespective of whether the company makes profit or not.
This can become a drag on the cash flow of the company, especially in start-ups or companies struggling in a highly competitive market. They are not patient enough!
We will look at other dimensions of capital in the next edition.
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