Capital Commitment: Definition, Examples, and Risks

What Is Capital Commitment?

A capital commitment is the projected capital expenditure a company commits to spending on long-term assets over a period of time.

It also refers to the securities inventory carried by a market maker. The capital commitment may also refer to investments in blind pool funds by venture capital investors, which they contribute overtime when requested by the fund manager.

Key Takeaways

  • Capital commitment refers to the projected capital expenditure a company will spend on long-term assets over a period of time.
  • Other areas that constitute capital commitments are the securities inventories of market makers and investments in blind pool funds by venture capitalists.
  • The most common areas of capital commitments include operating expenses, such as property-related costs, equipment, production materials, and future business ventures.
  • Risks associated with capital commitments include overextending an allocation of funds, with the possibility of a company not being able to meet other obligations.

Understanding Capital Commitment

In the business world, capital commitment revolves around the designation of funds for a particular purpose including any future liability. Most commonly, this includes regular operating expenses such as property-related costs, equipment, and production materials. Regardless of the circumstances in which the term is used, it relates to funds being held or directed in a particular manner.

Capital commitments may also include future business ventures such as the beginning of an expansion project. Capital commitments are generally higher for companies in capital-intensive industries such as power generation.

Capital commitments are not contingencies, which represent conditions or situations that cannot be predicted with any degree of certainty by the company.

Risks with Capital Commitment

Capital commitments may come with a variety of risks, even if the funds have not been released as payment. A company has to exercise care to structure its capital commitments since an inordinately high amount puts undue strain on the company’s finances.

Proper planning requires the company to ensure operating cash flow is sufficient to meet capital expenditures, and if it is not, to make arrangements to ensure it can raise the additional funds on the capital markets.

If a company overcommits and experiences a sudden unexpected decline in capital, it may have to direct a higher portion of the profits toward these commitments than originally intended. If it doesn't, it may be unable to meet all of its obligations in their entirety.

Due to these risks, these forms of commitments are disclosed within the released financial statements, often listed as a footnote in regards to the balance sheet.

Being able to access a company's capital commitment through its balance sheet allows investors to assess the risks involved with their investment.

Capital Commitment in the Stock Market

From a stock market perspective, capital commitments can refer to the shares held by a financial organization that are currently available for sale. They represent stock inventory in its entirety and may be considered a form of risk as the associated values of the shares vary with market conditions.

Capital Commitment in Private Equity

In private equity, capital commitment—or committed capital—is the amount of money an investor promises to a venture capital fund. Under most agreements, the investor usually has a certain timeframe in which to supply this capital. This commitment is generally used to fund investments or fees by fund managers.

This market comes with much more risk than that of public equity. That's because private equity returns have a higher dispersion of returns than the public market.