What it means
Every business needs resources before it can earn anything: premises, equipment, stock, staff and cash to bridge the gap between paying for those and being paid by customers. Capital is the collective name for those resources and the money that bought them.
It comes from two sources. Owners provide equity capital by investing money and by leaving profits in the business rather than taking them out.
Lenders provide debt capital through loans, bonds and other borrowing. The mix between the two is the capital structure, and it determines both the cost of the company's funding and the risk it carries.
Capital is not free. Lenders charge interest.
Owners expect a return, usually higher than lenders because they are paid last and bear more risk. The blended cost of debt and equity, weighted by the amount of each, is the weighted average cost of capital (WACC), and a business creates value only when it earns more on its capital than that cost.
This is why return on capital employed is one of the most watched measures of performance: it compares operating profit with the total capital used to generate it. The distinction between capital and revenue runs through accounting.
Capital expenditure buys assets that last for years and appears on the balance sheet; revenue expenditure covers day-to-day costs and goes through the income statement. Capital gains arise from selling assets for more than they cost, as opposed to trading profit.
Capital allowances and depreciation spread the cost of capital assets over their lives. Businesses fail for lack of capital as often as for lack of customers.
Undercapitalised companies cannot survive a slow quarter, cannot fund growth and pay heavily for the short-term credit they rely on. Overcapitalised companies, sitting on more cash and assets than they can use profitably, earn poor returns for their owners.
Managing capital means having enough, at an acceptable cost, and putting it to work at a return that exceeds that cost.
In practice
Real-world examples.
Example
A founder puts $50,000 of savings into a new business and the bank lends $30,000; the company starts with $80,000 of capital, of which $50,000 is equity and $30,000 is debt.
Example
A manufacturer with $20 million of capital employed and $3 million of operating profit earns a 15% return on capital, well above its 9% cost of capital.
Example
A retailer decides to lease rather than buy its new stores so that it can grow without raising additional capital.
Think of it
“Capital is like fuel for a vehicle. Without enough fuel, you can't go anywhere. Businesses need capital to power their operations and move toward their goals.
Formula
Calculation
Capital Employed = Total Assets minus Current Liabilities, which equals Equity + Non-Current Liabilities
Return on Capital Employed (ROCE) = Operating Profit / Capital Employed x 100%
Working Capital = Current Assets minus Current Liabilities
Worked example. A regional brewery's balance sheet and results:
- Total assets: $8,000,000
- Current liabilities: $1,500,000
- Non-current liabilities (long-term loans): $2,500,000
- Equity: $4,000,000
- Operating profit for the year: $780,000
- Interest rate on loans: 7%; return expected by shareholders: 12%
Capital employed = $8,000,000 minus $1,500,000 = $6,500,000 (check: $4,000,000 + $2,500,000 = $6,500,000)
ROCE = $780,000 / $6,500,000 = 12.0%
Weighted average cost of capital (ignoring tax for simplicity):
- Debt share = $2,500,000 / $6,500,000 = 38.5%; equity share = 61.5%
- WACC = 38.5% x 7% + 61.5% x 12% = 2.7% + 7.4% = 10.1%
The brewery earns 12.0% on capital that costs 10.1%, so it is creating value, but the margin of 1.9 percentage points is thin. A project to expand capacity should only proceed if it is expected to return more than 10.1%.Case study
Seen in the real world.
A software consultancy grew from 10 to 60 staff in three years on the strength of strong demand. The founders had never raised outside capital; the business was funded by retained profit and, increasingly, by an overdraft. Because clients paid 60 to 90 days after invoicing while staff were paid monthly, each new hire required roughly $30,000 of working capital before the first cash arrived, and the overdraft had grown to $1.4 million at a cost of 11%.
A prospective new client offered a contract that would have required 15 more hires and the bank refused to extend the facility. The founders faced a choice: turn away the work, or raise equity. They sold 20% of the company to an investor for $2 million, cleared the overdraft and funded the hires.
The dilution stung, but the business's return on capital was 28%, far above the investor's expected return, and every dollar of new capital was worth more inside the company than the ownership it cost. The consultancy tripled in size over the next four years.
Watch out
Common mistakes.
- Confusing capital with cash. Capital includes all the resources funding the business; cash is one asset among many.
- Growing without planning for the capital growth consumes. Each unit of extra sales usually ties up more working capital before it releases any.
- Measuring performance on profit alone. A profit of $1 million is excellent on $5 million of capital and poor on $50 million.
Questions
People also ask.
What is the difference between capital and equity?
Equity is the owners' capital. Total capital (capital employed) also includes long-term debt.
What is capital structure?
The mix of debt and equity a business uses to fund itself. More debt lowers the average cost but raises risk.
What does undercapitalised mean?
Having too little capital for the size of the business, so that it depends on short-term credit and cannot absorb setbacks.
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