What is Capital?
Capital is a term for financial assets (such as funds held in deposit accounts), as well as for tangible factors of production such as manufacturing equipment. Additionally, capital includes facilities, such as the buildings used to produce and store manufactured goods. Materials used and consumed as part of the manufacturing process do not qualify as capital.
BREAKING DOWN Capital
While money is used to purchase goods and services for consumption, capital is more durable and is used to generate wealth through investment. Examples of capital include automobiles, patents, software and brand names. All of these items are inputs that can be used to create wealth. Besides being used in production, capital can be rented out for a monthly or annual fee to generate income, and it can be sold when it is no longer needed.
Ongoing Service to Business
To qualify as capital, the goods must provide an ongoing service to the business to create wealth. Capital must be combined with labor, the work of individuals who exchange their time and skills for money, to create value. By investing in capital and foregoing current consumption, a business or individual can direct those efforts into future prosperity.
Tangible assets that function as capital within a business are subject to depreciation, which occurs as normal wear and tear on an item, diminishing its overall value. Depreciation is often noted on a business’s financial statements and may be eligible for use as a tax deduction.
The assertion of property rights designates the value of associated capital. Individuals or companies can claim ownership to their capital and direct its function to suit their needs. Ownership of capital can also be transferred to another individual or corporation, with any resulting proceeds from the sale being directed to the previous owner. For example, a business can sell a piece of production equipment to another facility in exchange for cash. The purchasing facility becomes the new owner of the equipment and the selling business can include the funds as revenue.
Types of Capital
- Debt Capital: A business can acquire capital through the assumption of debt. Debt capital can be obtained through private sources, such as friends and family, financial institutions and insurance companies, or through public sources, such as federal loan programs.
- Equity Capital: Equity capital is based on investments that, unlike debt capital, do not need to be repaid. This can include private investment by business owners, as well as contributions derived from the sale of stock.
- Working Capital: Defined as the difference between a company's current assets and current liabilities, working capital measures a company's short-term liquidity – more specifically, its ability to cover its debts, accounts payable and other obligations that are due within a year. In a sense, it's a snapshot of a firm's financial health.
- Trading Capital: Trading capital refers to the amount of money allotted to buying and selling various securities. Generally, trading capital is distinct from investment capital in that it is reserved for more speculative ventures. Trading capital is sometimes referred to as "bankroll." Investors may attempt to add to their trading capital by employing a variety of trade optimization methods. These methods attempt to make the best use of capital by determining the ideal percentage of funds to invest each time. In particular, in order to be successful, it is important for traders to determine the optimal cash reserves required for their investing strategies.
Additional Paid-In Capital
Additional paid-in capital is an account in the equity section of a corporate balance sheet. It represents the additional amount paid for a company’s shares over the par value of the shares. Additional paid-in capital only arises when a person buys shares directly from the company. The price paid for shares bought in the secondary market does not affect additional paid-in capital.
Usually, stock par value is intentionally kept low, often at $0.01 per share. Thus, the amount paid for a share bought from the company is mostly additional paid-in capital. Additional paid-in capital can apply to both common and preferred shares.
Assume ABC Inc. offers 10 million shares to potential shareholders. The shares have a par value of $5. Assume the shares are sold for $12 per share, which is $7 per share over the par value. ABC receives $120 million from this offering. This sale will be reflected on two different lines of the equity section in ABC’s balance sheet. The common stock line will reflect the portion ABC received for the par value ($50 million). The remaining $70 million will be reflected in the additional paid-in capital account line.
Capital vs. Money
People often interchange the words "capital" and "money," believing they mean the same thing. But there's a substantial difference between the two. Capital involves the aspects of the company that help shape and grow it, and includes any of its assets that can benefit the company in the long term, whereas money refers to the instrument used to purchase goods and services, serving a more immediate purpose.