Equity-capital: An Introduction
October 26, 2009, 8:20 pm
Copyright © 2009 Integrated Profitability TM
The “Small Business Finance & Profitability” (SBF&P) blog has received a request to cover “capital”:
“Good! Finally all of this is coming together for me. How about more on capital? What is it? where does it come from, is it actual & stored somewhere physically and separately or virtual like the net or sum of two or more numbers?”
“Capital” is a great topic and one the SBF&P blog hasn’t touched upon. Not even gotten close, although passing reference has been made to it from time to time. Capital is a critically important part of a company’s financial books. However, it can be somewhat esoteric; which means, it will take a few blogs to define, explain and clarify what capital is, why it is important and how it can be used.
This first article will be an introduction, providing a definitional foundation for more detailed articles in the future.
The prospect of a series of articles on financial capital will no doubt send some people screaming for any button on your keyboard that will return you to where you came from, close the browser or shut-down your computer. A pity.
To begin the discussion of capital, an introduction is in order. Of all the financial statements created to report on companies, two stand head-and-shoulders above the rest:
● The Income Statement
● The Balance Sheet
These may trigger big yawns for many, but do your best to stifle them. If these two reports don’t raise your heart rate, hang in there. Things get better. Trust me: I’m in finance.
Most of the “Small Business Finance & Profitability” blogs so far relate to the Income Statement because that is the statement that ends with “Net-Profit” as it’s bottomline (pun most definitely intended: if you didn’t know it before, you now know where that well-used word comes from. The opposite, top-line, is Revenue).
The Income Statement includes:
● Revenues
● Expenses
● Net-Profit (a calculation: Revenues minus Expenses)
The Balance Sheet includes:
● Assets
● Liabilities & Capital
The only calculation involved with the Balance Sheet is that “Total Assets” must equal “Total Liabilities plus Capital” because if these two aren’t equal, then they are out-of-balance…which would make the “Balance Sheet” a moot point (again, a useful pun indubitably intended).
With the main components of the two most important financial statements highlighted, the following observation might make sense:
“Capital is to Assets & Liabilities as Net-Profit is to Revenue & Expense”
Crystal clear isn’t it? Don’t worry if it’s not—as mentioned in the beginning, it will take several articles to better develop what capital is, where it comes from and why it’s vital to a company. The purpose of the comparison above is to highlight the critical importance of capital.
Still not highlighted? For a business, one of the closest conditions to Nirvana is having a healthy, growing, and positive Net-Profit. Which is an Income Statement item.
Similarly*, having a healthy, growing, positive Capital account is the Balance Sheet equivalent.
A harsh, but instructive, way of looking at the value of Capital is to imagine the liquidation of a company. The owners sell all the company’s assets and use the proceeds to pay off all the company’s liabilities. The cash left over is the monetization of the company’s capital.
For owners, the bigger that pile at the end of the rainbow is, the better.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 43
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
*: “Similarly” because “Net Profit” is a “period-bound” number: for example, one year. Nobody really ever gets upset if you make tons of money in one year. Unless you’re an oil company, or in some other industry that routinely ticks people off.
“Capital,” however, is a “perpetual” number: it keeps growing. After awhile, massive capital accumulation tends to become a problem, especially for company’s owned by shareholders: because as that mountain of wealth grows, they would like part of their share of it returned to them in the form of dividends.
Capital for a company is a lot like fat for people: having none is anorexic, having an attractive amount is healthy, having too much is overweight and have way more than one person can possibly carry around is morbidly obese.
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