When it comes to the expansion and financial success of a business, I’ve found that one of the most critical resources is capital. Be it starting, operating or growing a business, if someone understands how to utilize the financial resources available to them, it can be very beneficial. It is not enough to have cash in the bank. It is important to understand which resources are available, when they will be available, and how to best utilize them.
Knowing and understanding different forms of funding can help with many business decisions. For example, planning for the cost of paying employees and the purchase of inventory can be eased by knowing how to utilize the different funding sources available to the business.
A company can have outstanding sales and still be cash strapped due to the owner’s decision to plow all the cash flow back into the business to build up stock. Then, unexpected expenses and business needs can also be funded with the right form of capital.
This guide will help explain the concept of capital, its forms and where different funding comes from. I will also include an example of a financial calculation and explain other financial issues, as well as suggest ways to address them.
What Is Capital?
Capital is the money, resources, or anything a person or business can use to produce a good or service, or to help them make a profit or realize a future financial gain. In business finance, capital generally means money invested by the owners of the business, loans raised by the business, and other means of financial support for the business.
Let us consider the example of the person starting a small bakery. Before the bakery can start operations and serve customers, he/she will need money to buy ingredients, a display cabinet, oven, packaging and maybe cash to pay rent and employees before the bakery becomes profitable. Money invested in this capital helps the bakery serve customers.
Capital, revenue and profit are, however,r different. Revenue is the income realized from sales, and profit is what is left after costs and expenses are subtracted from the sales income. It is important for business owners to understand the difference between these three to be able to truly understand the financial state of their business and not to just assume that a business doing sales is a healthy business.
Why Is Capital Important in Business and Finance?
Businesses need funding to help them operate, address unexpected costs, and take advantage of growth opportunities. Insufficient funding can hurt even the best business. Imagine a situation where a clothing retailer receives a large order. The retailer, however, does not have the cash to buy the fabric or pay the suppliers. The opportunity is there, but the business cannot take advantage of it.
Of course, adequate funding allows a company to purchase more sophisticated equipment, hire better employees and improve its products and services. It can provide financial cushion when the business has a slump in sales.
More money is not necessarily better money. Poor spending decisions can drain the resources just as quickly as inadequate funding can constrain the growth of the business. I believe the main advantage comes from matching available resources to business priorities, having enough cash in the business to withstand the ebb and flow of the business, and making prudent and judicious investments.
What Are the Different Types of Capital?
Businesses need to identify many different types of resources. They need to be able to categorize these resources to understand how to fund them. These categories are as follows:
- Financial capital: Funds available for business investment and operation.
- Working capital: Resources required to meet the short-term financial obligations of a business.
- Fixed capital: Long-term business assets.
- Human capital: Employee know-how.
- Social capital: Value acquired from social networks and relationships.
- Debt capital: Funds borrowed from lenders.
- Equity capital: Funds contributed by owners and shareholders.
There is overlap between these categories. However, precision in their distinction is necessary for effective financial management. For instance, a company may use equity capital to purchase a machine, and the same machine may be considered a long-term business asset.
How Does Capital Work?
Capital is raised by obtaining resources, allocating them to productive activities, and assessing the outcome. Businesses can raise capital by getting loans from banks, raising capital from owners or reinvesting proceeds. After raising capital, it is used to buy raw materials, hire employees, and enhance the business operations. Let’ss look at an example. Assume a business invests $20,000. The business expects that capital will be transformed into equipment and inventory that will generate future sales. However, investment alone will not ensure the success of the business. The business must price its products in a way that will ensure sales, and control costs and expenses to ensure the business operates at a profit. Also, the investment may not ensure the business gets the expected customers.
During the various stages of a business’s growth, financial strategies are developed to enhance the business’s operations and address the challenges the business may be facing. These financial strategies may include raising capital to finance the launch of a new business, or to support the operations of an existing business.
What are the main sources of capital?
Businesses have several financing options, and the one chosen depends on the financial circumstances and plans of the business as well as the appetite of the business owners for risk.
Some business owners have the financial means to fund their businesses from personal sources (e.g. personal savings and/or retained earnings). Other owners choose to fund their businesses by incurring debt (e.g. through the implementation of a debt financing option or an equity financing option).
There are other financing options, such as venture capital and private equity financing. These may be appropriate for businesses with larger financing needs and high potential for growth. However, these financiers also may require a high level of control over business decisions.
Grants may be available for businesses through various governmental and non-governmental programs. However, grant funding is restricted and may be dependent on the policies of the awarding entity. There are several factors that businesses must consider when evaluating different funding options, such as costs, ownership, and the risks associated with the funding option.
Based on these factors, different funding options may be more or less appropriate for a given business situation. For example, a given funding option that may be appropriate for a rapidly growing business, such as a technology business, may not be as appropriate for a relatively slow-growing business, such as a local bakery.
What Is the Difference Between Capital, Revenue, and Profit?
These three financial terms are related, but confusing them can lead to poor decisions.
| Term | Meaning | Example |
| Capital | Financial resources invested or available to support business activities | An owner invests $15,000 to launch a shop |
| Revenue | Money earned through sales before deducting expenses | The shop generates $8,000 in monthly sales |
| Profit | The amount remaining after relevant expenses are deducted from revenue | The shop earns $1,200 after expenses |
Let’s say a business makes $8,000 in sales this month and incurs $6,800 in costs related to sales (e.g. inventory), rent, payroll, and other operating costs. In this case, the business would make a profit of $1,200.
Of course, this does not take into account the original investment. While sales obviously do not turn a profit immediately, some people seem to think this means the business is losing money. Similarly, a business can report a profit. However, if customers pay in accounting terms but not in cash terms, the business can still experience cash flow problems.
Being able to distinguish these means owners can gain a deeper understanding of various aspects of the business. This information can be very helpful when making financial decisions, for example, deciding how best to use the business’s capital.
How Do You Calculate Capital?
There is not one specific way to calculate each and every type of financial resource. This is why each calculation of capital can vary. One important type of capital that is crucial to the day-to-day running of a business is working capital.
The standard formula is:
Working capital = Current assets − Current liabilities
Cash and items that a business is expected to sell or use in its regular business operations are considered current assets. Accounts receivable is an example of a current asset. Current liabilities include obligations that are expected to be paid in the near term. Accounts payable is an example of a current liability.
Using the example of a retail business, if current assets are $30,000 and current liabilities are $18,000, the business has $12,000 in working capital. Working capital is the excess of current assets over current liabilities.
An excess of working capital may not mean that a business has sufficient cash to pay its obligations. The inventory of a business may not be easily saleable. Also, customers may pay a business after the due date of an invoice.
In order to make meaningful inferences about a business, an owner should analyze the details of the business and use forecasts of cash flows, rather than rely on a single figure, like working capital, to make an assessment.
What strategies should be employed to better manage a business’s financial capital?
To better manage a business, an owner should closely analyze cash inflows and outflows of a business to plan for the financial needs of the business. Owners should analyze the business’s accounts receivable, inventory, and cash to plan for future business needs.
A business should also budget realistically and shop for the best financing options. Major purchases should be evaluated to determine if expected demand for the business justifies the purchase. Coordinating the length of funding with the intent of the expense reduces the risk of exposing the expense to a longer-term funding source.
Managing the financial resources of the business generally requires making a series of trade-offs. A business needs to have sufficient working capital to meet its financial obligations, but have liquidity to take advantage of new business opportunities.
Also Read About: Viva Finance: Loan Rates, Requirements & Benefits
What are the Major Problems Associated with the Management of Capital?
Many businesses, regardless of the demand for their product or service, struggle financially. One major problem is the inability to obtain adequate working capital. Customer and supplier payment cycles, combined with the cycle of producing and distributing the product, can create an excess of inventory.
Borrowing money to expand the business, although desirable, creates an ongoing financial obligation that can strain the business, especially if the business does not realize adequate profits. Poor management and the inability to effectively control expenses are also major problems.
Let’s say a furniture manufacturer experiences an increase in sales and needs to expand its capacity. In the process, the manufacturer borrows money and, in the future, will have to repay the loan and service the interest. The manufacturer also needs to take into account the loss of sales that occurs in the furniture business during the off-season.
There are a number of ways a business can reduce uncertainty, including preparing and reviewing projections, monitoring and managing inventory and cash flow, and maintaining adequate financial statements.
Conclusion
Knowledge of financial resources offers business owners a platform to make informed decisions concerning planning, investment and sustainable growth. It is not about making the most financing possible. It is about making the right financings, using them prudently and maintaining the flexibility to respond to new opportunities and challenges.
Knowledge of the differences between working capital and fixed assets and between debt and equity financing helps owners make informed decisions concerning borrowing, reinvesting, purchasing and expanding.
My main learning is that financial management is about knowing exactly what the business needs at present, and anticipating what it might need in the future. It is about knowing how best to allocate current resources for long-term business value.
Frequently Asked Questions
1. What is capital in simple words?
It is money, property or other resources used to run a business. Examples are money spent to purchase machinery and equipment, and inventory.
2. What are the four main types of capital?
Typically, financial, human and social capital are discussed along with physical capital. Classification of business finance includes working and fixed capital, and debt and equity financing.
3. What is the difference between capital and money?
Money is a medium of exchange. Capital is a resource used for productive or investment purposes. Money can be invested in a business and become capital.
4. Can a business be profitable but have cash-flow problems?
Yes. A business may record sales and make profits while cash remains tied up in accounts receivable. Cash is needed to pay employees, suppliers and rent. So profit and cash should be monitored separately.
5. How can a small business increase its available capital?
A small business can retain earnings, improve its collection efforts, cut costs, sell assets, and consider loans and investments. The best option depends on the financial state of the business, how urgently the funds are needed, and the business’ readiness to take on additional debt and/or equity.
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