Capital is typically defined as money raised through debt and equity offerings. However, in economics and finance, the term “capital” has several different connotations.
Financial capital most typically refers to assets required by a business to deliver goods or services, as measured in money value.
Financial capital encompasses a far broader range of concepts than economic capital. In certain ways, everything can be considered financial capital as long as it has monetary value and is used to generate future revenue.
Most investors come across financial capital in the form of debt and equity. Measuring it may reveal both difficulties and opportunities.
Types of Financial Capital
Many businesses initially borrow from family members or their credit cards. They can seek bank loans and federal government support from the Small Business Administration once they establish a track record.
When a company becomes large enough, it can raise funds by selling bonds to investors.
The benefit of debt is that owners do not have to share profits. The negative is that even if the endeavor fails, they must repay the debt.
In the case of equity, the firm receives cash from investors now in exchange for a part of future profits.
Most entrepreneurs start with their own money. They invest their own money in the venture in the expectation of receiving a 100% return later on. If the company is profitable, it will invest some of the cash flow instead of spending it now.
Partners, venture capitalists, or angel investors are another source of equity. This strategy requires a company to give up some control in exchange for cash from investors. These investors become shareholders in the company.
When a firm gets extremely large and profitable, it might raise additional funds by issuing shares. This is known as an initial public offering (IPO). It means that any investor can buy the company’s stock. This is why stocks are also known as equities.
Supply chain financing is a common type of specialist capital. It’s similar to a company payday loan. Banks lend the company the invoice amount minus a charge. When the invoice is paid, they receive reimbursement for the loan.
The economic capital concept was initially created as a tool for internal risk management.
Most businesses estimate their economic capital using specialized formulae. The way we think about risks and how we calculate potential losses has evolved over time. Some risks are straightforward, such as credit risk on a loan, where the specific amount of potential loss is specified in a promissory note and may be updated for inflation. Operational risks are more difficult to manage, and opportunity costs are even more complex.
Once a company feels it has developed an accurate model for assessing economic capital, future business decisions can be made strategically to optimize the risk/reward trade-off.
What’s the Difference between Financial and Economic Capital?
Financial capital should not be confused with capital, which refers to one of the four elements of production that drive supply in economics. Economic Capital refers to durable commodities such as machinery, equipment, and tools. These are used to make other items.
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