If businesses ran on ideas and dreams, the life of an entrepreneur would be smooth sailing. But, just like human bodies, companies need fuel. The only difference is that a company’s fuel doesn’t come in the form of food and water; it comes in the form of capital.
Ideally, your business’s profits will be enough to keep it running and growing. That said, there may be times when you need more capital to get your idea off the ground or keep the lights on when the market slows down.
In that case, it’s essential to understand the different sources of capital and how to raise them when needed.
Table of contents:
- What is capital in economics and business?
- Is financing an example of capital in economics?
- Types of business capital
- Capital vs. capital assets
- The difference between capital and money
What is capital in economics and business?
In economics, capital is defined as anything that gives or creates value for the business or individual that owns it, which is a fairly broad term. In practice, economists and business owners often use the term capital to refer to the money and financing a business has to pay for its operations and growth strategies, such as hiring new employees.
Is financing an example of capital in economics?
Yes. Financing gives business owners access to cash capital that they can use to keep the business operating or invest in growth strategies, such as expanding to new locations.
The two most common types of financing are debt financing and equity financing. In the next section, you’ll learn how each of them works as a source of business capital.
Types of business capital
At some point, you may need to raise capital to get your business off the ground or keep it running during difficult times. Here are the four main sources of capital for businesses, plus the pros and cons of each one.
Working capital is the money you have left over after using your current assets to pay for current liabilities. Current assets include resources you can liquidate within one year, like cash, inventory, and accounts receivable. Similarly, current liabilities are the payments you owe within the next year, which typically include your regular operating expenses along with taxes and short-term debts.
You can calculate your company’s capital using the following formula:
Working Capital = Current Assets - Current Liabilities
Increasing your company’s working capital can help you free up cash flow and cover expenses in the short term. Here are a few steps you can take to improve working capital:
- Implement a hiring freeze to keep labor costs steady
- Use promotions, product bundles, or discounts to move slow inventory
- Choose vendors that offer discounts or negotiate better payment terms with existing suppliers
- Improve your customer payment collections by incentivizing early payments or offering more payment methods
Advantages of working capital:
- It doesn’t dilute your ownership
- You can increase capital without taking on debt
Disadvantages of working capital:
- Improving working capital may not be enough to continue business operations or fund expansions
Debt capital is financing that you obtain by borrowing from others. Often, debt capital refers to taking out business loans from banks or other financial institutions. That said, it also includes borrowing from friends and family, opening a credit card account, and applying for government-backed programs like Small Business Administration (SBA) loans.
Unlike working capital, debt capital involves paying back the money you borrowed over time, typically with interest. With 72% of small businesses reporting they have some outstanding debt, loans are considered a normal part of starting and running a business,
Still, you don’t want to overwhelm your business with interest payments. As such, it’s important to do your due diligence and have a specific purpose in mind when you take out a loan.
Max Shak, founder and CFO of the financial publication nerDigital, recommends that business owners “understand the total cost of the loan, including interest rates, origination fees, and any hidden costs, and assess whether the repayment schedule aligns with your business's cash flow.”
Doing so helps ensure you can raise capital without putting excess financial burden on your business.
Advantages of debt capital:
- It doesn’t dilute your ownership
- Your interest payments are tax deductible
- You don’t owe lenders a portion of future profits
Disadvantages of debt capital:
- Too much debt can increase your company’s financial risk
- The original amount of money must be repaid, usually with interest
- Lenders may be able to seize your assets if you can’t make payments
Equity capital is money that comes from selling shares in your company, which can be done privately or publicly.
Private equity is a popular startup funding method that involves raising equity by selling shares of your company to a group of private investors. Public equity refers to money that you get from selling shares on a stock exchange, which is what happens if you go through an initial public offering (IPO).
For younger companies, private equity funding is more relevant because it allows you to raise capital and connect with firms that specialize in helping early-stage businesses grow.
Unlike debt capital, equity capital doesn’t involve making repayments with interest. Instead, investors receive a portion of your future profits in exchange for their money upfront.
As a result, investors take on more risk than financial institutions who give out loans. So, if you want to obtain equity funding, you need to have a strong business plan that illustrates how you’ll use the investment to create income.
Dave Chester, owner of the home automation company Custom Controls, also recommends creating a thorough budget to earn trust. He explains, “By setting up a budget, you can show investors that you're committed to your firm and that you'll manage their money wisely.”
Advantages of equity capital:
- Allows you to raise funds without taking on more debt
- You don’t need to make regular repayments or pay interest
- Equity investors may provide experience, expertise, and relationships
Disadvantages of equity capital:
- You give up partial ownership of the company
- Equity investors are entitled to a portion of your future profits
Trading capital refers to the money that’s available to a business to buy and sell on financial markets. It usually applies to financial institutions like brokerages, asset management firms, and investment banks.
These companies do business by investing other people’s money for them and charging a fee for the service. As such, the trading capital comes from the money other people give them to invest on their behalf.
For most business owners, trading capital is not a funding source, but it’s relevant if you want to get into investment banking or asset management.
Advantages of trading capital:
- Does not require repayments with interest
- Can be used to generate income through investments
Disadvantages of trading capital:
- Only applies to specific financial institutions
- Can only be used for trading on financial markets
Capital vs. capital assets
Capital refers to the financial resources that fuel your business, while capital assets are specific types of non-financial assets that you can use to generate value for your business over the long term.
For example, if you have a factory that produces the goods you sell, it’s a capital asset because you are using it to generate income over a long period of time.
Capital assets can be tangible or intangible. Here are some common types of capital assets in business.
- Human capital: the knowledge, skills, and capabilities of your workforce
- Physical capital: tangible goods or equipment used in a business’s production process, such as factories and machinery. This type of capital is one of the four factors of production, along with land, entrepreneurship, and labor
- Intellectual capital: intangible assets that create value for a company, including company culture, human capital, and business relationships
One of the main differences between capital and capital assets is liquidity. Capital includes money and financing, which are both liquid. You can use them immediately to pay for your ongoing operations. Capital assets are usually illiquid, meaning they can’t be quickly converted into cash to pay for expenses.
The difference between capital and money
Capital is described as the money businesses use to pay for day-to-day operations. In other words, the money is being put to work and used to generate more income. That said, not all money is considered capital. Instead, money becomes capital when it’s used to grow your business. If you have funds stored in a personal bank account, you have money, but you’re not using it as capital.
There are times when your business’s income isn’t enough to keep the lights on or invest in growth. As a result, raising financial capital is an essential skill for most business owners. Understanding the advantages and disadvantages of different types of capital can help you determine the best strategy for you.