There are several types of capital in economics and business. Some contribute directly and are used to produce goods and services. Meanwhile, others contribute indirectly. And, here, we discuss four of them:
- Physical capital
- Financial capital
- Human capital
- Natural capital
Physical capital or capital goods are man-made tools used to produce goods and services, such as machines and equipment. That is what “capital” means in the economist’s definition when describing factors of production or economic resources. It is one of four economic resources besides land, labor, and entrepreneurship.
Physical capital is vital because it provides economic benefits to businesses. It contributes directly, which companies use to assist and support the production of goods or the provision of services. For example, a manufacturing company uses machinery to process raw materials into intermediate or final goods.
If the accumulated physical capital increases, we expect the company to produce more output. Improved quality also contributes to increased output, for example, by adopting more sophisticated technology. So companies can increase production by investing in more capital or better quality technology.
Furthermore, the company reports fixed capital as fixed assets. In financial statements, you may know it as property, plant, and equipment (PP&E). Businesses often spend a lot of money on them to increase their production capacity. The dollars they spend we call capital expenditures.
Then, to measure whether the company’s capital expenditure increases the company’s production capacity or not, you must also take the depreciation of fixed assets into account. Depreciation represents the fixed assets’ lost economic benefits, for example, due to wear and tear. When capital expenditure increases higher than depreciation, the company’s production capacity increases. On the other hand, if depreciation is faster, production capacity will decrease.
In economics, the difference between capital expenditure and depreciation, we call it a net investment. Meanwhile, economists refer to capital expenditure as a gross investment. Later, economists used the term “capital consumption allowance” to refer to depreciation.
Financial capital includes cash and other financial instruments. Examples are stocks, bonds, accounts receivable, bank overdraft (bank overdraft), leasing, factoring (factoring), and retained earnings.
Companies use financial capital for day-to-day operations such as paying bills and buying inputs, or for expansion such as buying capital goods (physical capital). It is like blood for our body, without which business cannot run.
Specifically, companies use long-term financial capital to make more money in the future. For example, they raise funds by issuing stocks or bonds to buy new machines, allowing them to produce and sell more output.
What are the types of financial capital? In general, it falls into two categories:
- Equity capital
- Debt capital
Equity capital denotes the ownership interest in the company. It is long-term capital and can be common stock and preferred stock, both of which have different priority claims and voting rights.
- In the early days of the business, it came from the injection of the founder. Then, the company may sell shares to the public for the first time through a stock exchange (called a second share offering). If it still needs equity funds, the company can also issue new shares later (right issue).
Debt capital represents the obligation for the company to return the principal plus interest. It can be short-term or long-term debt. The source can come from borrowing from banks and issuing debt securities.
- Unlike equity capital, companies must repay debt regardless of their financial performance and condition. They have to pay interest and principal even when they are not generating income. Failure to meet obligations can encourage creditors to file for bankruptcy against the company in court.
Another capital in business is working capital. It is current assets minus current liabilities, representing money left over from day-to-day operations.
- Current assets include several items such as cash and cash equivalents. The other components are short-term investments, inventories, and accounts receivable, which the company expects to convert into cash within one operating cycle (usually one year).
- Current liabilities include items such as short-term debt and trade payables. They represent obligations that must be paid by the company during one operating cycle. The current portion of long-term debt – which will mature within one year – also falls into this category.
So, if working capital is positive, the company still has money left after paying its current liabilities (usually one year). Therefore, it is usually more desirable as it indicates good liquidity.
Human capital represents the knowledge, skills, and abilities inherent in individuals. It provides future economic benefits by making them more productive. It is accumulated through experience, training, and education.
Health is also human capital. When we are healthy, we are more productive and can perform various productive activities.
In a company, human capital represents the quality aspect of workers. It determines their productivity. By being more productive, they can produce more or faster output for the same input. They should also be compensated for the wages or salaries they receive.
Then, quality human capital also determines economic progress. For example, some countries are poor in natural resources, such as South Korea and Japan, but their economies are developed. The reason is, they have superior human resources, with a high work ethic, and are more productive.
Natural resource-poor countries invest in two other factors: labor and entrepreneurship. Their workforce is more productive. And, their entrepreneurship gave rise to various businesses to produce technologically advanced capital goods.
Thus, human capital does not only promote economic growth through increased productivity. But, it also encourages innovation. Entrepreneurship stimulates new businesses to come up with innovative ideas.
In discussing the factors of production, economists specify natural capital as land. It includes land and various natural resources on Earth, such as metallic minerals, fossil energy, air, biodiversity, and global climate. They are vital for our survival and production now and in the future.
We use natural capital as an input to produce goods and services. For example, we use the land for the location of factories and warehouses. Service companies also use it to, for example, construct retail spaces and office buildings, where they provide services.
Then, we use mining and agricultural products as raw materials. For example, we use mined metallic minerals such as bauxite, tin, nickel, copper, and iron to produce various intermediate products. They then went into other manufacturers to produce cars, cables, electronic devices, and heavy equipment.
Then, we also use plantation and agricultural products for various products such as processed foods and beverages. For example, we process soybeans and palm oil into cooking oil. Then, we also use rubber latex as raw material for producing tires, wood in the forest for furniture production, and fiber for paper.
Some other products can also be directly consumed by us. For example, agriculture produces staple foods and fresh fruit, which we can directly consume without entering the manufacturing sector.
We also use other natural resources as indirect inputs. For example, we use air, geothermal, and water to generate electricity, which is used to supply energy for various business purposes, from manufacturing to retail.