What’s it: In a broad definition, based on Lexico.com, capital refers to wealth owned by individuals or companies and available or contributed for a specific purpose such as starting a company or investing. It can be money or other assets, both financial assets such as securities or real assets such as factories and machinery.
Capital plays a vital role for companies and the economy. Physical capital contributes directly to producing goods and services such as machinery, equipment, and logistics vehicles. Meanwhile, companies need financial capital to buy these items. For instance, when you start a new business, you need a start-up capital to purchase essential capital goods or rent a production site. It can come from your own money, from family or relatives, or from external loans.
Are money and other financial capital a factor of production in the economist’s definition? Later, we will discuss it below. Now, let’s get started with the various capitals in business and why are they important?
The importance of capital
Physical capital is vital for companies. Therefore, when capital accumulation increases, for example, by purchasing new machines, we expect the business to generate more output. Previously, the business had 10 machines with 100 units per hour each, producing 1,000 units per hour. Now, the company has 12 machines with the same capacity and can produce 1,200 units of output per hour. Here, we are talking about an increase in output due to increased quantity (number of machines).
The next point is quality. It is also important to increase production. When companies buy more technologically advanced machines, they can produce more goods and services. For example, new technology allows the machine’s production capacity to increase from 100 to 120 units per hour. With the same number of machines, the company can produce more machines because they are of more sophisticated quality.
In addition, with more sophisticated machines, workers are also more productive. For example, a manufacturing company can produce output quickly using computer-aided machines rather than manual machines. Computers help the production process run automatically and require less technical operations from workers.
Does operating a business just involve physical capital such as machinery and equipment? No, there is financial capital. However, it also falls into several categories.
Financial capital is just as vital as physical capital in operating a business, although they do not contribute directly. When new, businesses need a start-up capital to purchase critical capital equipment or lease production sites. It can come from cash from the owner or from other sources.
Then, when the business is operational, the company needs working capital to purchase raw materials, pay bills to suppliers and build inventory. It is money for daily needs, namely the difference between current assets (cash and asset items converted into cash) and current liabilities (short-term debt and trade payables).
When a successful business survives, the owner wants to grow the business. They seek to increase their competitive and income-generating capacity. Thus, they pursue growth in business size, either with internal or external growth strategies.
And, to develop and grow a business, companies need financial capital. So they often issue stock or debt securities to finance business expansion, perhaps by acquiring other companies or building new production facilities.
By expanding, the business increases production capacity. With it, companies can produce and sell more products. In addition, companies can gain higher economies of scale, enabling them to produce at lower costs, which is important for strengthening competitiveness.
Can the money spent increase the company’s production capacity or not? You should compare capital expenditures with the depreciation of fixed assets.
Depreciation represents the lost economic benefits of fixed assets, for example, due to wear and tear. For example, the production capacity of the machine is 100 units when it is newly purchased. But, since it was old and worn, it could probably only produce 90 units.
Thus, if capital expenditures exceed depreciation, we expect capacity to increase. In contrast, if the capital expenditure is lower than the depreciation rate, the production capacity decreases.
Capital in economics
Now, let’s talk about capital from an economist’s perspective.
Economists define capital as a man-made tool used to produce goods and services. It refers to physical capital such as machinery, equipment, and vehicles. It excludes money and financial capital.
In economics, capital is one of the four factors of production besides land, labor, and entrepreneurship. All four are inputs to produce goods and services. Without them, there is no production and no business. Meanwhile, the reward for capital is interest.
Why do economists exclude financial capital as a factor of production?
Financial capital, such as money, does not contribute directly to production. For example, a business cannot process money into cars as aluminum is a raw material. Or, they can’t use it to help process raw materials into cars. Have you ever seen a car manufacturer produce cars using money instead of robotic machines and workers?
Businesses use financial capital such as cash, equity capital, and debt indirectly in the production process. Specifically, money only facilitates economic transactions. For example, in manufacturing cars, as in the case above, they need it to buy raw materials (aluminum) and capital goods (machinery).
In the company’s report
Both physical capital and financial capital, the company presents it in the financial statements, which record the resources owned by the company and claims to those resources. So, where can we see capital as in the economist’s definition?
First, we discuss financial capital.
In accounting, financial capital is divided into two main categories:
- Equity capital
- Debt capital
Equity represents the shareholder’s contributed capital and represents ownership of the company. It is long-term capital. As compensation, shareholders are entitled to dividends distributed by the company and can get capital gains from stock price appreciation.
Debt comes from creditors, such as banks and debt securities investors. It can be short-term or long-term. Examples are bank loans, commercial paper, notes, and bonds. The company is obliged to repay the principal plus interest.
Both are in the liabilities and equity section of the balance sheet. And when analyzing growth prospects and solvency, analysts usually focus on long-term capital; growing a business is a long-term project.
Next is working capital. It represents money left over from day-to-day operations and equals current assets minus current liabilities. For example, the company has positive working capital. It shows you, the company has money left over to finance day-to-day operations such as buying raw materials, paying wages, and paying trade debts.
Now, we discuss physical capital as mentioned by economists. It refers to fixed capital. In the financial statements, you might find it as a property, plant, and equipment (PP&E) account. Companies use it to produce products.
In buying fixed assets, companies rely on long-term financial capital. For example, they issue shares or debt securities. From the money raised, they can use it to buy fixed assets. How much is spent? That’s capital expenditure (CAPEX). It is possible to maintain or increase the current productive capacity. As I stated above, we need to compare it with depreciation to see the impact of capital expenditure on increasing production capacity.