Financial capital


Financial capital is any economic resource measured in terms of money used by entrepreneurs and businesses to buy what they need to make their products or to provide their services to the sector of the economy upon which their operation is based. In other words, financial capital is internal retained earnings generated by the entity or funds provided by lenders to businesses in order to purchase real capital equipment or services for producing new goods or services.
In contrast, real capital comprises physical goods that assist in the production of other goods and services.

IFRS Concepts of Capital Maintenance

To provide useful information, it may be necessary to classify equity claims separately if those equity claims have different characteristics. Under the International Financial Reporting Standards, the choice of the "Capital Maintenance" concept determines the accounting model used for preparing financial reports.

The Three Concepts of Capital Maintenance

Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power. Accordingly, IFRS recognizes three distinct concepts:
ConceptDefinitionMeasurement UnitBasis for Profit
Financial Capital is synonymous with net assets/equity.Nominal Monetary UnitsProfit is earned if nominal money equity increases.
Financial Capital is the invested purchasing power.Units of Constant Purchasing PowerProfit is earned if invested purchasing power increases.
Physical CapitalCapital is the productive/operating capacity.Physical Units Profit is earned if physical productive capacity increases.

Defining Financial and Physical Capital

Financial capital generally refers to saved-up financial wealth, especially that used in order to start or maintain a business. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity.
Conversely, under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day. This requires a measurement basis of current cost rather than historical cost.

Subcategorization of Financial Capital

Academics and practitioners often subcategorize financial capital based on its operational or regulatory function:
  • Productive capital: Assets necessary for daily business operations.
  • Signaling capital: Used to signal a company's financial strength to shareholders and the market.
  • Regulatory capital: Capital maintained to fulfill mandatory capital requirements.

    Capital market

  • Long-term funds are bought and sold:
  • * Shares
  • * Debenture
  • * Long-term loans, often with a mortgage bond as security
  • * Reserve funds
  • * Euro Bonds

    Money market

  • Financial institutions can use short-term savings to lend out in the form of short-term loans:
  • * Commercial paper
  • * Credit on open account
  • * Bank overdraft
  • * Short-term loans
  • * Bills of exchange
  • * Factoring of debtors

    Differences between shares and debentures

  • Shareholders are effectively owners; debenture-holders are creditors.
  • Shareholders may vote at AGMs and be elected as directors; debenture-holders may not vote at AGMs or be elected as directors.
  • Shareholders receive profit in the form of dividends; debenture-holders receive a fixed rate of interest.
  • If there is no profit, the shareholder does not receive a dividend; interest is paid to debenture-holders regardless of whether or not a profit has been made.
  • In case of dissolution the firm's debenture holders are paid first, before shareholders.

    Types of capital

Fixed capital

Fixed capital is money firms use to purchase assets that will remain permanently in the business and help it make a profit. Factors determining fixed capital requirements:
  • Nature of business
  • Size of business
  • Stage of development
  • Capital invested by the owners
  • location of that area

    Working capital

Firms use working capital to run their business. For example, money that they use to buy stock, pay expenses and finance credit. Factors determining working capital requirements:
  • Size of business
  • Stage of development
  • Time of production
  • Rate of stock turnover ratio
  • Buying and selling terms
  • Seasonal consumption
  • Seasonal product
  • profit level
  • growth and expansion
  • production cycle
  • general nature of business
  • business cycle
  • business policies
  • Debt ratio

    Own and borrowed capital

Capital contributed by the owner or entrepreneur of a business, and obtained, for example, by means of savings or inheritance, is known as own capital or equity, whereas that which is granted by another person or institution via debt instruments is called borrowed capital, and this must usually be paid back with interest. The ratio between debt and equity is named leverage. It has to be optimized as a high leverage can bring a higher profit but create solvency risk.
Borrowed capital is capital that the business borrows from institutions or people, and includes debentures:
  • Redeemable debentures
  • Irredeemable debentures
  • Debentures to bearer
  • Ordinary debentures
  • bonds
  • deposits
  • loans
Own capital is private capital that owners of a business provide, sometimes called owners equity. The ownership interest is typically represented in preferred shares, and may be of various types, for example:
  • Preference shares/hybrid source of finance
  • * Ordinary preference shares
  • * Cumulative preference shares
  • * Participating preference shares
  • Ordinary shares
  • Bonus shares
  • Founders' shares
These typically have preference over the common shares. This means the payments made to the shareholders are first paid to the preference shareholder and then to the equity shareholders.

Instruments

A contract regarding any combination of capital assets is called a financial instrument, and may serve as a
  • medium of exchange,
  • standard of deferred payment,
  • unit of account, or
  • store of value.
Most indigenous forms of money and the modern fiat money are only a "symbolic" storage of value and not a real storage of value like commodity money.

Valuation

Normally, a financial instrument is priced accordingly to the perception by capital market players of its expected return and risk. Unit of account functions may come into question if valuations of complex financial instruments vary drastically based on timing. The "book value", "mark-to-market" and "mark-to-future" conventions are three different approaches to reconciling financial capital value units of account.

Issuing and trading

Like money, financial instruments may be "backed" by state military fiat, credit, or precious metals resources. Governments generally closely control the supply of it and usually require some "reserve" be held by institutions granting credit. Trading between various national currency instruments is conducted on a money market. Such trading reveals differences in probability of debt collection or store of value function of that currency, as assigned by traders.
When in forms other than money, financial capital may be traded on bond markets or reinsurance markets with varying degrees of trust in the social capital of bond-issuers, insurers, and others who issue and trade in financial instruments. When payment is deferred on any such instrument, typically an interest rate is higher than the standard interest rates paid by banks, or charged by the central bank on its money. Often such instruments are called fixed-income instruments if they have reliable payment schedules associated with the uniform rate of interest. A variable-rate instrument, such as many consumer mortgages, will reflect the standard rate for deferred payment set by the central bank prime rate, increasing it by some fixed percentage. Other instruments, such as citizen entitlements, e.g. "U.S. Social Security", or other pensions, may be indexed to the rate of inflation, to provide a reliable value stream.
Typically commodity markets depend on politics that affect international trade, e.g. boycotts and embargoes, or factors that influence natural capital, e.g. weather that affects food crops. Meanwhile, stock markets are more influenced by trust in corporate leaders, i.e. individual capital, by consumers, i.e. social capital or "brand capital", and internal organizational efficiency, i.e. instructional capital and infrastructural capital. Some enterprises issue instruments to specifically track one limited division or brand. "Financial futures", "Short selling" and "financial options" apply to these markets, and are typically pure financial bets on outcomes, rather than being a direct representation of any underlying asset.

Broadening the notion

The relationship between financial capital, money, and all other styles of capital, especially human capital or labor, is assumed in central bank policy and regulations regarding instruments as above. Such relationships and policies are characterized by a political economy – feudalist, socialist, capitalist, green, anarchist or otherwise. In effect, the means of money supply and other regulations on financial capital represent the economic sense of the value system of the society itself, as they determine the allocation of labor in that society.
So, for instance, rules for increasing or reducing the money supply based on perceived inflation, or on measuring well-being, reflect some such values, reflect the importance of using financial capital as a stable store of value. If this is very important, inflation control is key - any amount of money inflation reduces the value of financial capital with respect to all other types.
If, however, the medium of exchange function is more critical, new money may be more freely issued regardless of impact on either inflation or well-being.