“Business capital” is often used interchangeably with “cash,” but the real meaning is broader than that. Once you know the definition, you’ll have a better understanding of how to use capital to build a successful, profitable company. So what is capital in business?
What is business capital?
Business capital is anything that increases a business’s ability to generate value, including cash, investments, and outside funding. Assets—such as property, equipment, patents, and more—are a type of business capital, because they are items of value owned by a company.
The more wisely you spend and invest business capital, the more successful your business will become.
Why do businesses need capital?
Without some source of capital, a new business may never get off the ground. Even established businesses need capital to attract investors and build the financial stability to grow. Without cash or other items of value, it is easier for businesses to become stagnant
Capital can help indicate the overall strength of your business. If you ever want to sell your business, your total capital, including assets, can help show potential buyers the value of the company. They may use your capital in ways you might not expect, such as selling off various assets to invest in other industries.
Evaluating a company’s investment quality
There are three broad measurements that investors use to evaluate the company’s investment quality:
- Working capital
- Asset performance
- Capital structure
Efficiently managing these three categories will make your business more appealing to investors, so you can earn additional funding to help your business grow.
Working capital is the difference between a company’s current assets like cash, accounts receivable, inventories of raw materials, and finished goods, and its current liabilities, such as accounts payable, and debts. If a company has substantial positive working capital, then it should have the potential to invest and grow.
Asset performance measures a firm’s ability to generate profits or returns from the assets held on its balance sheet. Asset performance is typically used to compare one company’s performance over time or against its competition.
Capital structure is a permanent type of funding that will grow with a company and its assets. A healthy capital structure should show a low level of debt and a high amount of equity. Your company’s debt-to-equity ratio (D/E ratio) can help investors decide if your business is worth investing in, because the ratio shows how risky your borrowing practices have been. Risk isn’t always a bad thing: it can be a source of growth for certain companies.
Debt-to-equity ratio: Total liabilities / total shareholders’ equity
i.e. $180,000 / $75,000 = 2.4 D/E ratio
Let’s break it down. Debt comes from taking out loans that have to be paid back no matter what, so even if your business performs poorly you will still owe the same amount. This is why debt has greater risk.
Equity works differently—it allows investors, such as venture capitalists or shareholders, to own part of a company. This means as the value of the company grows, so does the equity, and as the value of a company decreases, the equity goes down with it.
Your company’s industry and size will help determine the capital structure that’s right for you. Industries with unpredictable cash flow are usually not a good fit for debt-based financing. Smaller companies may struggle to grow without a high amount of debt.
Assets vs. money
For businesses, an asset is a significant piece of property that will be useful for longer than a year, and is not intended to be sold as part of the business model. So a company car is an asset, while a truck sold by an automobile company is not. Your assets likely serve an important purpose in your business, and they also add to the overall value of the company.
Money is simply cash that you have immediate access to without having to sell anything. Similarly, a “liquid asset” is a term often used to describe anything that can be quickly converted into cash, such as stocks.
When you apply for loans or grants, or when you ask for funding from investors, they will likely need to know the details about the value of your assets and how much money you have on hand. So be sure to keep track of these elements of your finances.
A common mechanism businesses use to keep track of company assets is a balance sheet. A balance sheet organizes assets and liabilities into two columns based on what the company owes and what it owns. This helps owners, lenders and investors remain aware of the current financial position of the business.
How do businesses use capital?
Companies can use capital to invest in anything that can create value for their business. The more value it creates, the better the return for the business.
Capital is crucial to a business for both short-term and long-term success. Some of the reasons for this are obvious—for example, you’ll need cash to pay for expenses such as rent, equipment, inventory, and other operating costs.
Capital can also be used in less direct ways, which can include using assets as collateral for loans or selling assets for cash to finance other needs.
Types of business capital
When talking about business capital, there are a few terms that will be helpful to familiarize yourself with as you’re talking to potential investors or buyers: working capital, equity, and debt.
As discussed above, working capital is the difference between a business’s liabilities and its current assets. For example, if your business has $10,000 in cash, and also $6,000 in debt, that gives you a total of $4,000 in working capital. If you want to create rapid growth for your business, or if your business is in the startup phase, you’ll likely need a large amount of working capital.
Equity is a useful way of measuring the value of a business. It’s the value of all of the company’s capital, plus the value of all assets if they were sold, minus all of the debts. This may sound similar to working capital, but it includes the value of the assets that can be sold. For example, if your business has $10,000 in cash, $6,000 in debt, and machinery that could be sold for $5,000, then your total equity is $9,000.
This one is straightforward: business debt is any amount of money that your business owes, whether it’s to a bank or investor. Just like personal debt, business debt can be useful, as it helps build credit, and taking out loans can help your business reach various goals.
Types of capital assets
Because assets are a type of business capital, business capital includes a variety of assets within your business, including current, tangible, and intangible assets.
Current assets are essentially cash, and cash is an important part of any business—especially those that are just starting out. And if you are trying to grow your business, this category is essential. Growth can be expensive, and whether you are increasing inventory, expanding into new markets, or creating a budget for a new marketing strategy, it will take cash to make a change.
Current assets include capital such as cash and other assets that can quickly be converted into cash.
- Accounts receivable
- Marketable securities
- Prepaid expenses
Almost any established company will have numerous tangible assets. Many of them are investments necessary for the success of your business, but not all of them can be quickly sold for cash. The larger your company grows, the more tangible assets you will likely need to sustain that growth.
Tangible assets are things that physical exist in your business. Often referred to as a fixed asset, or property, plant, and equipment (PP&E).
- Company cars
- Brand names
- Bank accounts
They may not have a dollar value, but sometimes intangible assets are priceless. Though you can’t sell off the goodwill you have in the marketplace or the talented teams you have built, leveraging intangible assets like these can help you take your business to the next level.
Intangible assets have have no physical presence in your business. It can be difficult to determine the value of these assets, and they often don’t appear in financial reports.
- Human capital
- Trade secrets
- Intellectual property
- Contractual rights
Capital gains and losses
Not every investment you make in your business will pay off. Capital gains and losses describe the way investments play out over time.
- Capital gains occur when your investment is worth more than its purchase price.
- Capital losses occur when your investment is worth less than its purchase price.
Capital gains and losses are important to understand when you start filing business taxes. If you are investing business capital in the stock market, and you receive a profit on that investment, you will have to pay the capital gains tax. The tax rate will vary depending on whether these are long term (investments held for more than a year) or short term (investments held for less than a year).
It’s also possible that capital losses can be declared deductions on your tax returns. Once your investment is sold for less than the price you paid, making it a realized loss, it can offset realized gains that are realized in the same year. Unfortunately, only $3,000 worth of capital losses can offset earned and other income in a year. If your capital loss is more than $3,000, the excess amount can be carried forward in future years with a $3,000 limit per year.
When filing your taxes, you cannot deduct unrealized losses, which are losses on investments you haven’t yet sold. This is because the value of that investment may change before you sell it.
Be sure to speak with your financial advisor to understand how these tax laws apply to you and your business specifically.
How to raise capital for a business
You know that you need capital for a successful business, but where will that money come from? You have several options available to you, and you will likely need a combination in order to raise all of the capital you’ll need. Keep in mind that how you choose to fund your business can also have a big impact on how it runs, especially if you use angel investors or investments from venture capitalists.
Like individuals, businesses carry their own credit score. In order to establish that credit, there are specific steps that must be taken. Here are three ways to start improving your credit to work towards raising your business capital.
- Get a business credit card: Your credit file is initiated once you open a line of credit. For most businesses, the quickest and most useful way to achieve this step is to get a corporate card. Start with one, and consider adding one or two more as your need grows. You should always keep a manageable balance on the card and never miss a payment.
- Work with vendors who report your activity: Not all suppliers and vendors are required to report payment histories to a credit bureau. Choosing to work with a supplier or vendor who does report these payment histories can help to build business credit.
- Get incorporated: Transitioning your business to an LLC helps to separate personal credit from your business credit. This can simultaneously improve both scores and improve your business capital.
Business loans are a more traditional debt-based funding route. Venture capital firms and investors take losses, but banks do not.
Government-backed loans come with low interest rates, but have strict requirements.
Personal loans require good credit, have higher interest rates, and can be difficult for startups with no track record to qualify for. If you go this route, shop around and compare prices beforehand.
The SBA loan program is also a route of funding that is designed by the Small Business Administration and extended through preferred lenders (usually banks and credit unions) exclusively for small businesses.
Small businesses can be defined in many ways and have diverse needs for funding, so the Small Business Administration provides several different loans with different criteria.
These types of business loans are generally very popular and can give small business owners terms that regular lenders can’t match; however, they’re also trickier to get and may come with more parameters for application and use.
Additionally, SBA loans can take much more time to apply for and obtain.
Government funding is a great option to help raise the capital you need to get your business where it needs to be. These grants are awarded by the U.S. government with strict criteria, but do not have to be paid back or come with a loss of stake in your business.
However, this route to raising capital can be difficult and require an extensive application process. Grants are few and far between and often industry-specific, so be sure to do the research before going after grants to help raise capital in your business.
You can also seek out funding from angel investors and venture capitalists. These two groups provide funding to entrepreneurs as an investment in a company’s future. In exchange for this funding, both will expect some amount of business equity, and possibly a role in how the company operates. The main differences between these two types of investors are when they invest and how they work.
Angel investors are wealthy individuals who provide startup capital to entrepreneurs in exchange for a percentage of equity in the company. This means they can be a good choice for brand-new businesses.
An angel investor may want to act as a mentor as you develop your business, so it’s important that they’re knowledgeable about your industry and the investment you’re offering.
Venture capitalists do not pay out of pocket, but rather invest other people’s money in order to create a profit. These investors tend to work with existing, established businesses, so they likely won’t choose to fund a business that is still in the idea stage.
In exchange for their investment, they will expect equity in the business, and may want to be on the board of directors for the company. Venture capitalists tend to look for big investments, so they will likely only consider your business if there is the potential for millions in profits.
In order to gain funding from either of these investors, you’ll need to present your business as a successful enterprise with lots of room for growth. They will likely need to see your business plan, financial statements, and financial projections.
It’s possible that you won’t just need a single infusion of capital when your business is in its infancy—you may need to raise funds several times over many years, and each time you do this it’s called a funding round.
Sometimes this funding is just enough to get to the next milestone, but you can set whatever financial goal you choose.
Each round of funding you complete will likely involve a lot of work: research, communication, relationship building, and demonstrating to investors that your company will give them a healthy return.
In the end, capital is the lifeblood of any business, and if you have to do another round of funding to get where you need to be, it’s worth it.