What it means
Every business is funded from two basic sources. Owners contribute equity, either as cash for shares or as profits they leave in rather than take out, and lenders contribute debt in the form of loans, bonds, overdrafts and lease obligations.
Corporate capital is simply the sum of those two, and it must equal the long-term assets and working capital they have financed. The distinction between the two sources drives most funding decisions.
Debt is cheaper because interest is a contractual cost that usually reduces the tax bill, but it must be repaid on a fixed schedule whatever trading is like. Equity is more expensive and permanent, and it carries no obligation to pay anything in a bad year.
Finance teams use the capital figure as the denominator for the ratios that judge performance. Return on capital employed compares operating profit with the capital tied up in the business, and the weighted average cost of capital sets the minimum return a new project must clear.
A company that consistently earns more on its capital than the capital costs is creating value; one that does not is quietly destroying it. The mix matters as much as the total.
Too little debt can mean shareholders are earning less than they could, while too much leaves a company exposed to a downturn, a covenant breach or a rise in interest rates. Most boards therefore set a target range for debt as a share of total capital and manage towards it over several years.
One common source of confusion is that "capital" is used narrowly and broadly. In the narrow legal sense, share capital is only the nominal amount subscribed for shares; in the broad management sense used here, corporate capital covers all long-term funding including retained earnings and borrowings.
Working capital is different again, referring to the short-term money tied up in stock, debtors and creditors.
In practice
Real-world examples.
Example
A family bakery chain wants to open twelve new sites. It has $9,000,000 of retained earnings and borrows a further $6,000,000, taking corporate capital to $15,000,000 with debt at 40% of the total, a level the bank's covenants allow.
Example
A software business raises a funding round rather than borrowing, because its revenues are still lumpy and it cannot promise fixed repayments. Its capital is almost entirely equity, which is expensive but leaves the company free to survive a slow year without breaching anything.
Example
A utility with predictable regulated income runs debt at 60% of total capital, far higher than a fashion retailer would dare, because the cash flows that service the interest are stable and long-dated.
Formula
Calculation
Total corporate capital = total shareholders' equity + interest-bearing debt
Take a manufacturer whose balance sheet shows ordinary share capital of $30,000,000 and retained earnings of $45,000,000, so equity is $30,000,000 + $45,000,000 = $75,000,000. It also has bank term loans of $40,000,000 and lease liabilities of $10,000,000, giving debt of $50,000,000. Total corporate capital is $75,000,000 + $50,000,000 = $125,000,000.
The mix is therefore $50,000,000 / $125,000,000 = 40% debt and $75,000,000 / $125,000,000 = 60% equity. If operating profit for the year is $18,750,000, return on capital is $18,750,000 / $125,000,000 = 15%. With a cost of equity of 10% and an after-tax cost of debt of 4.5%, the weighted average cost of capital is (0.60 x 10%) + (0.40 x 4.5%) = 6.0% + 1.8% = 7.8%, so the business earns 15% on money that costs 7.8% and is adding value.Case study
Seen in the real world.
This is an illustrative, fictional scenario. Tallow Ridge Foods, an invented ready-meal producer, had grown for a decade on retained profits alone and carried no debt, with corporate capital of $40,000,000, all equity. Its return on capital was a respectable 14%, but the founders were frustrated that a new chilled line kept being deferred for lack of funds.
The finance director modelled adding $16,000,000 of term debt at an after-tax cost of 4%, bringing total capital to $56,000,000 with debt at roughly 29% of the total. The extra capacity was forecast to lift operating profit enough to hold return on capital near 13% while raising the return earned by shareholders on their own money.
The board approved the borrowing but set a ceiling of 35% debt to total capital and required a rolling twelve-month cash forecast at every meeting. The illustrative point is that the decision was about the mix and the guardrails, not simply about whether more money was available.
Watch out
Common mistakes.
- Confusing corporate capital with cash in the bank, when capital is the funding raised and cash is only one of the assets that funding may currently be sitting in.
- Ignoring lease liabilities and other interest-bearing obligations, which understates debt and flatters both the capital mix and return on capital.
- Assuming no debt is automatically prudent, when a total absence of borrowing can mean shareholders are carrying more risk and earning less than they need to.
Questions
People also ask.
Is retained profit part of corporate capital?
Yes, profit left in the business is shareholders' money reinvested and forms part of equity.
How is corporate capital different from capital employed?
They are usually close in value, but capital employed is measured from the asset side as total assets less current liabilities, while corporate capital is measured from the funding side.
What is a sensible level of debt?
It depends entirely on how predictable the cash flows are, with stable regulated businesses comfortably running far more debt than cyclical or early-stage ones.
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