To run a business, you need capital. Businesses and economies, alike, constantly need capital to meet their day-to-day requirements. The capital capacity and allocation in a company defines the functionality of a company, and on the basis of the capital distribution ascertain whether the company is doing well or not.
But what exactly is capital? Is it just currency or a synonym for money? What happens when there is a capital crunch in a business? In this blog, we answer all these questions below.
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What is capital?
Capital is the wealth in the form of money or assets that you invest in a business with the motive of generating further income. When you invest capital in a capital it is either to expand the business or to pay off existing debt of a company.
For instance, if an investor has Rs. 1 lakh, of which he intends to invest Rs. 50,000 in cash in a business and machinery worth Rs. 20,000, then the capital of the business is Rs. 70,000.
Features of capital
- Capital can be defined as any form of money, asset or wealth you invest in a business or production activity or company
- Capital is extremely important for production activities and growth of a business
- Money and capital are different concepts
Difference between money and capital
Money and capital cannot be used interchangeably.
This is because money is a broader term and includes all currency notes and coins minted by the Reserve Bank of India (RBI). In contrast, capital is only that part of the money which is used for the production of income. It can include cash as well as financial and non-financial assets used in a business to produce income.
Capital also has a cost attached to it. For instance, debt capital has interest payments, and equity capital has dividends or capital gains. However, money does not have any associated financial cost.
You may also like our blog on ‘Investment’. Visit the Tickertape blog to read more.
Importance of capital for a business
To run a business, capital is essential. Without capital it is not possible to establish a business. For a business, capital plays an integral role in the following ways –
- Crucial for production– A business requires capital to fulfil its short-term needs for producing goods and services as well as long-term needs for investing in certain tools, machinery, and infrastructure.
- Creates employment opportunities– Every business needs human resources for its successful operations, and every business requires a certain amount of capital. Therefore, capital helps generate more employment opportunities in the country.
- Increases productivity– With the advent of technology in today’s business world, every business requires updated machinery and tools for increased productivity. Therefore, capital is required for the purchase of such assets.
- Core of economic development– Economic development is not possible without infrastructure, production of goods and services, etc.; all of this is not possible without capital. Thus, it plays a significant role in the development of any economy.
Types of capital for business
There are broadly four types of capital in accounting for a business-
- Working capital
Working capital is the amount of money a business needs to meet its short-term obligations and liabilities. This includes money needed for the supply of raw materials, the cost of holding inventory, employee salaries, etc. You can calculate the amount of working capital needed by subtracting current liabilities from current assets.
To have optimum working capital, it is very important for you to calculate the current requirement as well as estimate future needs depending on the cyclicity of your business, change in demand for your product, etc.
- Debt capital
Debt capital is a type of capital that the owner borrows from an external party to invest in a business. This external party may be a bank, financial institution, other corporates, the public, etc. Debt capital needs to be paid on a mutually decided date in the future.
Debt capital has a financial cost attached to it which is known as interest payments. Interest payments are tax deductible and might prove to be beneficial for your business. However, you need consistent cash flows to meet your interest obligations and a good credit rating to raise debt.
- Equity capital
Equity capital is a type of capital that is raised in exchange for ownership in the company. This ownership in the company is called shares.
Equity shareholders bear all risks for the company as well as enjoy the rewards either in terms of dividends or capital appreciation (of the shares). Additionally, equity shareholders have limited liability to the extent of their ownership in the company. Equity shares do not have any maturity date, and the company is under no obligation to redeem the shares.
Additionally, the company is also under no obligation to pay regular dividends. On the other hand, increased equity dilutes ownership and control. Due to the higher risk in equity, the cost of equity exceeds the cost of debt.
- Trading capital
Trading capital is the type of capital needed to trade in various securities. There is no minimum trading capital limit for a business to trade in securities.
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These types of capital in commerce result in either gains or losses. Here’s the difference between the both –
Capital gains meaning
Capital gains are profits earned on selling fixed and financial assets such as machinery, equity shares etc. These are non-recurring and do not occur due to the regular course of business. Capital gains also depend on the nature of the business. For example, profit on the sale of shares is a capital gain for a manufacturing business but not for a brokerage firm.
Capital gains might be long-term or short-term. Short-term capital gains come from the sale of assets that are typically held for less than 1 yr. On the other hand, long-term capital gains come from the sale of assets that are held for more than 1 yr.
Capital losses meaning
Capital losses are losses on selling fixed or financial assets, such as shares, buildings, etc. These are non-recurring and do not occur due to the operating activities of a business. Capital losses are deductible. This means that capital losses can be used to offset capital gains of the same kind. However, the maximum capital loss that can be deducted is only Rs. 1,500.
Conclusion
Capital is a significant part of building a business and strengthening the economy in the current business world. Different types of businesses might have different capital requirements. In fact, the capital of a company also determines if the company can be publicly listed or not. It is also true that capital structure helps determine a company’s creditworthiness. Therefore, you must know how to use your capital optimally.
FAQs
- What is capital in economics?
Ans. Capital is typically assets held in any form, liquid or otherwise, that are required for production activities and to meet the short-term and long-term needs of an economy.
- What is fixed capital?
Ans. Fixed capital is the capital of a business that is used by a business to meet long-term needs, such as purchasing equipment, furniture, etc.
- What are the factors that affect the capital structure of a business?
Ans. Some factors that affect the capital composition are- business size, competition, risk aversion, control, cost of capital, creditworthiness, taxation policies, earnings, stage of the life cycle, etc.
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