What is capital?
– Capital is any money or asset that a person or organization uses to produce value or generate returns. That can be cash earmarked for investment, physical tools and buildings, financial securities, or intangible assets such as patents. In practical budgeting for a firm, capital usually means liquid funds that are committed to operations or expansion.
Key definitions (first use explained)
– Capital: assets or funds used to create additional value.
– Working capital: short-term funds available for day-to-day operations (current assets minus current liabilities).
– Debt capital: money borrowed that must be repaid with interest.
– Equity capital: funds raised by selling ownership (shares) or retained profits.
– Capital structure: the mix of debt and equity a company uses to finance its assets.
– Trading capital: funds a financial firm or trader allocates specifically for securities trading.
– Liquidity: how quickly an asset can be converted to cash without large loss of value.
Why capital matters
– Capital lets a business pay suppliers and employees, run production, and invest in growth. Economists also treat capital as a core input for producing goods and services and an indicator of wealth at the household, corporate, or national level. Regulators require banks to keep minimum capital buffers to absorb losses and protect the financial system.
Where capital appears on financial statements
– On a company balance sheet, capital items can be on the current side (cash, marketable securities, inventory) or the long-term side (property, plant, equipment, intellectual property). Financing shows up as liabilities (debt) and owners’ equity.
Main types of capital and typical uses
– Working capital: funds for short-term needs—payroll, inventory, supplier invoices.
– Debt capital: bank loans, bonds, or other borrowings used for large investments or working capital; requires scheduled repayment and interest.
– Equity capital: funds from selling ownership (stock) or reinvesting profits; no fixed repayment but dilutes ownership.
– Trading capital: capital set aside specifically for trading positions in financial firms.
Common sources of capital
1. Internal cash flows (operating profits).
2. Debt financing (bank loans, bonds, credit lines).
3. Equity financing (issuing shares, private investment).
Note: Small businesses may also rely on personal funds, friends & family, or government loan programs.
Key analytical metrics (what analysts watch)
– Debt-to-equity ratio = Total debt / Total equity. Measures leverage.
– Debt-to-capital = Total debt / (Total debt + Total equity). Another leverage measure.
– Return on equity (ROE) = Net income / Average equity. Shows profitability for owners.
– Weighted average cost of capital (WACC) = blended after-tax cost of debt and cost of equity used to evaluate investment returns.
Short checklist before raising or committing capital
1. Identify purpose: working capital, expansion, acquisition, or trading.
2. Estimate required amount and timing.
3. Compare cost: interest rates vs. expected return on investment.
4. Assess liquidity needs and covenant restrictions (for debt).
5. Model impact on ratios (debt/equity, coverage ratios, WACC).
6. Consider tax effects and dilution (for equity).
7. Maintain a reserve for unexpected shortfalls.
Worked numeric examples
1) Working capital (simple)
– Current assets: cash $120,000; inventory $80,000; receivables $50,000. Total current assets = $250,000.
– Current liabilities: accounts payable $90,000; short-term debt $30,000. Total current liabilities = $120,000.
– Working capital = Current assets − Current liabilities = $250,000 − $120,000 = $130,000.
Interpretation: The business has $130,000 available to cover near-term obligations.
2) WACC (blended cost of capital)
Assumptions:
– Market value of equity (E) = $60 million.
– Market value of debt (D) = $40 million.
– Cost of equity (Re) = 10% (investor-required return).
– Pre-tax cost of debt (Rd) = 5%.
– Corporate tax rate (T) = 21% (U.S. federal rate for illustration).
Steps:
– Total capital = D + E = $100 million.
– Equity weight = E / (D+E) = 0.60; Debt weight = D / (D+E) = 0.40.
– After-tax cost of debt = Rd × (1 − T) = 5% × (1 − 0.21) = 3.95%.
– WACC = (E/(D+E))×Re + (D/(D+E))×Rd×(1−T)
– WACC = 0.60×10% + 0.40×3.95% = 6.0% + 1.58% = 7.58%.
Interpretation: Projects should return more than ~7.6% to add value, given these inputs. (WACC is sensitive to the assumptions—use market values and realistic cost estimates.)
Practical considerations and cautions
– Debt increases leverage and can amplify returns but also insolvency risk if cash flows fall short.
– Equity avoids scheduled repayments but dilutes existing owners and can be more expensive (higher required return).
– Maintain sufficient working capital to avoid operational disruptions.
– For banks and large financial institutions, regulators mandate capital buffers to absorb losses—this is separate from operational capital planning.
– Always test multiple scenarios (stress tests) for revenue, interest rates, and cash flow variability.
Explain like I’m five
– Think of capital as tools and money a lemonade stand uses: the cash to buy lemons (working capital), the pitcher and table (physical capital), and the money a parent lent to buy them (debt) or gave in exchange for a share of future profits (equ
ity — like a parent who gave you money but expects a slice of future lemonade profits instead of fixed repayments. If the stand does great, the parent benefits; if it loses money, the parent shares the loss.
Quick checklist for managing capital (small business / simple example)
– Know your current assets and current liabilities monthly. (Current assets = cash + inventory + receivables.)
– Keep a buffer of working capital to cover lulls (rule of thumb: 1–3 months of operating costs).
– Match financing term to asset life: short-term needs with short-term finance; long-term investments (equipment) with long-term finance.
– Monitor leverage: track debt-to-equity and interest coverage.
– Run at least three scenarios quarterly: baseline, optimistic, and stressed (sales down, costs up).
– Revisit cost of capital assumptions when interest rates or risk profile change.
– Keep records for covenant compliance if you have bank loans.
Worked numeric example — lemonade stand
Assumptions (simple):
– Cash = $20
– Inventory (lemons, sugar, cups) = $30
– Accounts receivable (negligible here) = $10
– Current liabilities (bills, supplier credit) = $25
– Owner equity invested = $50
– Bank loan (debt) = $30
– Owner’s required return (cost of equity, Re) = 12% (owner’s target)
– Bank loan rate (Rd) = 5%
– Corporate tax rate (T) = 21% (used only if applying tax shield to debt)
1) Working capital
– Working capital = Current assets − Current liabilities
– Current assets = 20 + 30 + 10 = $60
– Working capital = 60 − 25 = $35
2) Current ratio (liquidity gauge)
– Current ratio = Current assets / Current liabilities = 60 / 25 = 2.4
3) Leverage (debt-to-equity)
– Debt-to-equity = Debt / Equity = 30 / 50 = 0.60
4) Weighted Average Cost of Capital (WACC) — a simple capital cost measure
– WACC = (E/(D+E)) * Re + (D/(D+E)) * Rd * (1 − T)
– E = 50, D = 30, so E/(D+E) = 50/80 = 0.625; D/(D+E) = 0.375
– WACC = 0.625*0.12 + 0.375*0.05*(1 − 0.21)
– WACC ≈ 0.075 + 0.0148 = 0.0898 ≈ 8.98%
Interpretation: the stand needs to earn a return above ~9% on its invested capital (after tax benefit of debt) to cover financing costs on average. Assumptions: chosen Re, Rd, and tax rate are illustrative; small businesses may not use corporate tax shields the same way as corporations.
Key formulas and definitions
– Working capital = Current assets − Current liabilities. (A liquidity measure.)
– Current ratio = Current assets / Current liabilities. (Above 1 = assets exceed short-term obligations; higher is more conservative.)
– Debt-to-equity ratio = Total debt / Total equity. (Leverage indicator; higher = more borrowed relative to owner funds.)
– WACC = (E/(D+E))Re + (D/(D+E))Rd(1 − T). (Average after-tax cost of capital used for valuation and investment decisions.)
– Capital expenditure (CapEx) = money spent to buy or upgrade physical assets (e.g., new juicer).
– Return on Capital Employed (ROCE) = EBIT / (Total assets − Current liabilities). (Measures operating profitability relative to capital employed.)
Practical stress-test checklist (quick)
1. Reduce sales 20% and recalc cash flow for next 6 months.
2. Increase raw-material costs by 10% and recalc gross margin.
3. Raise interest rate on variable debt by 200 bps and recalc interest expense.
4. Identify non-essential spending to cut and estimate runway extension.
5. Estimate breach risk for any loan covenants; prepare mitigating actions (defer payments, raise equity, renegotiate terms).
When to prefer debt vs equity (brief)
– Debt: use for predictable cash flows and shorter-term needs; cheaper (interest deductible) but requires repayment and raises insolvency risk if cash flows drop.
– Equity: use for growth investments or when cash flows are uncertain; no scheduled repayments but dilutes ownership and typically has a higher required return.
Sources for further reading
– Invest
opedia — Investopedia: https://www.investopedia.com/terms/c/capital.asp
Additional sources for practical guidance and reference
– U.S. Securities and Exchange Commission (Investor.gov) — How to read financial statements: https://www.investor.gov/introduction-investing/investing-basics/how-read-financial-statements
– U.S. Small Business Administration (SBA) — Loans and managing business finances: https://www.sba.gov/funding-programs/loans
– Khan Academy — Accounting and financial statements (free tutorials): https://www.khanacademy.org/economics-finance-domain/core-finance/accounting-and-financial-statements
– Federal Reserve Education — Business finance basics and interest rates: https://www.federalreserveeducation.org
Practical checklist to finish the short-term analysis (use in order)
1. Update base monthly cash-flow model for next 6–12 months.
– Inputs: opening cash, monthly revenue (by product), COGS, operating expenses, tax assumptions, debt service (interest + scheduled principal), capex, working-capital needs.
2. Run three scenarios: Base, Stress (10–30% lower revenue), Shock (sudden cost increase or interest shock).
3. Recompute key metrics:
– Runway (months) = Available cash / Net monthly cash burn.
– Gross margin = (Revenue − COGS) / Revenue.
– Interest coverage ratio (ICR) = EBIT / Interest expense.
– Debt-service coverage (if lender uses it) = EBITDA / (Interest + Principal repayments).
– Leverage ratio = Net debt / EBITDA (if applicable).
4. Identify covenant thresholds from loan docs and flag any projections that cross them.
5. Prepare mitigation options, prioritized by speed and feasibility (cash conservation, short-term financing, covenant waivers, asset sales, equity raise).
6. Build a one-page lender summary: current position, forward 6‑month forecast, covenant status, requested relief (if any), and proposed timeline.
Worked numeric examples
Example A — Runway and gross margin impact
– Assume: Opening cash = $500,000; monthly revenue = $200,000; monthly COGS = $120,000; other OpEx = $60,000; interest & principal = $20,000/month.
– Base net monthly burn = (COGS + OpEx + Debt service − Revenue) = (120k + 60k + 20k − 200k) = $0 (break-even).
– If raw-material costs +10% → new COGS = 120k × 1.10 = 132k.
– New net monthly burn = (132k + 60k + 20k − 200k) = $12,000.
– Runway =
Runway = Opening cash / new net monthly burn = 500,000 / 12,000 ≈ 41.7 months (about 3.5 years).
Interpretation and quick actions
– A one-time 10% rise in raw-material cost turned a break-even company into one burning $12,000/month. With $500k cash that gives plenty of runway, but the company should treat the change as a recurring hit to margins unless it can reverse it.
– If management wants to restore break-even without using cash, compute the required revenue or cost actions (worked below).
Worked follow-ups and how to size fixes
1) Restore break-even by raising price (revenue)
– Needed revenue to break even = COGS + OpEx + Debt service.
– With new COGS = 132,000; OpEx = 60,000; Debt service = 20,000:
– Revenue_needed = 132,000 + 60,000 + 20,000 = 212,000/month.
– Percentage increase required = (212,000 − 200,000) / 200,000 = 6.0%.
– If demand is price‑elastic, this may not be feasible; perform demand sensitivity analysis before proceeding.
2) Restore break-even by cutting OpEx
– To reduce burn from 12,000 to 0, OpEx must fall by 12,000 (all else equal).
– New OpEx target = 60,000 − 12,000 = 48,000/month.
– Evaluate which expense lines can be reduced (discretionary SG&A, marketing, contractors) without harming revenue.
3) Partial fixes and runway improvements
– Example: Cut OpEx by 10,000/month (modest reduction).
– New net burn = 132,000 + 50,000 + 20,000 − 200,000 = 2,000/month.
– New runway = 500,000 / 2,000 = 250 months (longer because burn is much smaller).
– Note: Very small burns produce very long theoretical runways, but operational risk and one-off shocks remain.
4) How big a cost shock produces a 12‑month runway?
– Desired burn to exhaust cash in 12 months = 500,000 / 12 ≈ 41,667/month.
– Solve for COGS that yields that burn:
– COGS_required = desired_burn + Revenue − OpEx − Debt service
– = 41,667 + 200,000 − 60,000 − 20,000 = 161,667/month.
– That implies COGS would need to rise from 120,000 to ≈161,667 — a 34.7% increase — to compress runway to 12 months (absent other actions).
Checklist for management when margins worsen
– Recalculate runways for several scenarios (base, −5%, −10%, −20% margin shocks).
– Estimate elasticity: how much revenue would fall if you raise prices X%?
– Prioritize non-linear
non-linear cost reductions and one-time measures (e.g., pause discretionary projects, temporary hiring freeze, supplier renegotiation) before cutting fixed capacity that would permanently harm revenue.
Immediate checklist (first 24–72 hours)
– Recompute current cash burn and runway.
– Cash burn (monthly) = (COGS + OpEx + Debt service) − Revenue.
– Runway (months) = Cash on hand / Cash burn (if burn > 0). If burn ≤ 0, runway is indeterminate (cash is increasing).
– Run three scenario runs: base, −10% gross margin, −20% gross margin. Keep assumptions explicit (unit volumes, price, fixed vs. variable cost behavior).
– Identify urgent fixed outflows you can pause or defer (non-critical capex, marketing campaigns, bonuses) and quantify near-term savings.
– Open lines of communication with lenders and key suppliers; request covenant waivers or extended payment terms if appropriate.
– Prepare a short investor/stakeholder note summarizing scenarios and planned actions.
Short-term actions (7–30 days)
– Prioritize variable cost reductions: renegotiate COGS with suppliers, switch to lower-cost sourcing, or reduce input usage.
– Model price changes using assumed demand elasticity (elasticity = %Δquantity / %Δprice) before implementing price increases.
– Implement hiring freeze, limit overtime, delay non-essential hires.
– Tighten working capital: accelerate receivables, lengthen payables where contractually feasible, reduce inventory.
– Run a cash-sensitivity table that shows runway under combinations of price change, volume change, and cost shock.
Medium-term actions (30–90+ days)
– Reoptimize product mix to favor higher-margin SKUs.
– Reassess long-term contracts and fixed commitments; negotiate deferrals or restructurings.
– Evaluate financing alternatives: revolving credit, term loans, asset-backed lending, equity bridge (note: discuss with counsel).
– If structural margin decline is likely, prepare a strategic replan that includes permanent cost base reduction and reallocation of capital.
Worked numeric example — using the numbers from earlier context
Assumptions: Revenue = $200,000/mo; OpEx = $60,000/mo; Debt service = $20,000/mo; Cash reserve = $500,000; baseline COGS = $120,000/mo.
1) Baseline monthly cash burn
Burn = COGS + OpEx + Debt − Revenue = 120,000 + 60,000 + 20,000 − 200,000
= Continued worked numeric example =
1) Baseline monthly cash burn (completed)
Burn = COGS + OpEx + Debt − Revenue = 120,000 + 60,000 + 20,000 − 200,000 = 0
Interpretation: monthly cash burn (shortfall) = $0; business is operating at breakeven on a cash-flow basis. Cash reserve remains available for one-off needs, working-capital swings, or investment.
Note: “Burn” = monthly cash shortfall (negative means surplus). “Runway” = cash reserve ÷ monthly burn (months until cash exhausted). Runway is undefined/infinite when burn ≤ 0; in practice you still keep reserves for shocks.
2) Scenario A — 10% revenue decline (price