In the hit musical Hamilton, the second act has a song entitled the “Room Where It Happens.” Along with introducing the use of a banjo into hip-hop style music, the song covers a famous compromise in United States history. Alexander Hamilton agrees to move the capital of the new country from New York City to the Maryland–Virginia area in exchange for Virginians James Madison and Thomas Jefferson approving Mr. Hamilton’s financial plan. The plan called for the federal government to become responsible for the Revolutionary war debt of the states. It also effectively allowed for the formation of a central bank. Mr. Hamilton saw the need of the newly independent United States to have access to capital to grow and diversify its economy. He saw that the best way for the new country to have credibility in the capital markets of that time was to repay all the debt from the war and not allow some states to default and others to stay solvent. Mr. Hamilton traded location of the capital for control of the nation’s financial capital, highlighting what capital he viewed as being more valuable.
The little pun at the end of the first paragraph shows how the word capital can be used in different ways. Even within the world of economics it is used in many ways. In its simplest form, capital is wealth. It can be in the form of physical capital, such as a house, a factory, or a copyright. It can also be in a financially liquid form like cash, stocks, a bank account, or even a line of credit has value.
Capital formation brings benefits to companies, individuals, and nations and is a common economic goal. Capital can be used as a tool to improve the quality of life, as a storage mechanism of wealth, as a means of production, or consumption. Capital flows are critical to companies and countries, they use it to pay for maintenance and expansion and use it as a safety net in weaker times. Monitoring the general access to capital as well as the amount and type of capital available and what type of capital is being used is critical in understanding micro and macro investment themes.
Capital is often thought of in its more liquid forms, like cash or securities investments. This type of capital formation is viewed as being initiated by savings and is one of the reasons savings rates are monitored by investors. A simple example of how savings helps access to capital would be a person deposits money into a bank, the bank uses the money to loan it to others to capitalize a new business or borrow money to buy a new car. Another example could be when a person puts money into a mutual fund that buys the stock of a company either giving that company more money to expand or increasing the value of its stock.
There is a significant amount of capital in less liquid forms, such as a manufacturing plant or a brand name. Home equity loans tap into the excess capital of a home and transform it into liquid capital. Capital exists in all types of less liquid assets from a car to a Picasso painting. There are increasingly new ways of tapping into some of this capital. If a person wants to use a room in their house and rent it out over the internet they are tapping into a previously underutilized part of their capital to generate income. Underutilized or untapped capital has great potential. A Peruvian economist, Hernando DeSoto, has written extensively on how developing countries must utilize their less liquid forms of capital and government institutions need to improve how they monitor ownership so people can use this illiquid capital as surety to gain access to more liquid capital and grow their businesses.
Today flows of international capital and global supply chains link together corporations from diverse countries so that various nations’ economies are more intertwined than before. Some writers have felt that this has reduced international conflicts and some of this fluid capital has helped development in some poorer countries. Digital information, improved communications, greater institutional consistency, as well as the growth in assets of nonbank financial institutions have all helped capital to be more mobile than in the past.
Market systems generally allow capital to go where it will get the best return. This usually results in capital going where there is growth and to companies that are seeing demand for their products and services. This differs from systems where a third party decides where capital should go, even if there is no demand for it. Like a government program that decides to use capital to send milk to dairy farmers or a copy of Das Kapital to a Kindergarten.
This does not mean that market systems always have the fairest flows of capital or the fairest access to capital, but market systems do allow for capital to generally flow toward people’s freely selected choices. Technology is increasing the accessibility and therefore fairness of capital flows. In Indonesia they have had some of the highest proportion of unbanked adults of any nation, however it has incredibly high mobile phone penetration and firms are seeing rapid and massive take up in e-banking offerings through mobile phones helping make access to capital more broadly available, some of this is being driven by an internet-based ride hailing company that has offered a mobile wallet service to its drivers.51
Corporate capital typically comes from a combination of three sources. The first is cash generation at the company. Second is from equity capital that is created by selling an ownership stake in the company. Third is from borrowings. The amount of capital that a company can raise from third parties is usually based on their perception of the value of the assets of the business on the open market. The value is typically based on the ability of those assets to generate cash flow.
The amount of liquid capital available to people, businesses, and nations can impact the ability to grow the economy or weather an unexpected crisis. Understanding capital availability can help you make investment decisions. At one point most capital for companies came from banks and equity offerings, but there has been significant innovation in finance and it is getting increasingly harder to accurately trace availability. In some countries there are good surveys that can help gauge capital availability. These might include measures of business and individual confidence as well as surveys of bank lenders. There are also databases of public equity and debt financings as well as syndicated bank loans. When optimism is high, capital is usually more readily available.
Whichever sources you choose to monitor, try to notice changes in the direction of capital availability and the mix of the capital being raised. Too much debt or equity issuance can be troublesome signs. Debt is often considered to add more risks into an economy, though if too much equity capital is being raised it may mean company managements’ see valuations near a top or investors are too willing to invest indiscriminately.
Keep track of the type of sectors of the economy that look like they can raise capital and those that can not, it can be an important differentiator. If a sound industry can not attract capital it may face major problems, keep in mind that in many cases bank lenders are getting monthly financial reports. Changes in what the bank lenders are doing may be early signals about a company’s or an industry’s health.
Equity sources of capital have become more varied than in the past. At one point in history this was almost exclusively private, sort of a friends and family circle of investors. With the help of the development of the limited liability company capital, in the form of public stock, became more readily available. More recent innovations have been private equity, venture capital, crowd funding, and even the television show Shark Tank, where entrepreneurs compete to win equity capital for their early stage companies.
Debt capital has been available for centuries. However, debt capital has taken on many forms over time. In the modern system, banks can process more loans because they often take the fees and sell off the bulk of the loan to other investment pools, such as mutual funds (increasing the danger of moral hazard.)52 Bond structures have become increasingly creative. In addition, there are mezzanine loans, microfinance lending, and direct lending sources available. There are also a variety of securitizations that can raise capital on any number of assets that offer a relatively predictable stream of cash flows, from communications towers to credit card debt. Securitized debt was even issued backed by anticipated music royalty streams, the first bond securitized by music rights was done using David Bowie’s first twenty-five albums, and these bonds were dubbed Bowie Bonds.53
Much of this financing is being done without traditional banking through investment firms, family wealth offices, major pension funds, and government’s sovereign wealth funds. Creative financing has come from many areas. There are also online sources now to raise equity and/or debt. The increasingly varied sources of capital and increased speed at which capital can be raised is becoming more important to the economy but all of these developments make it more difficult to find meaningful statistics on capital raising and renders some of the older data, which is mainly based on bank borrowing and public equity raises, less valuable.
Short-Term Capital
Businesses are often in need of short-term capital for operations. This can be because of seasonality in their business, a sudden surge in demand, or perhaps shocks to their supply chain or logistics. The world of short-term finance can be critical to a company and make a meaningful difference in their financing costs.
There are many options to fund short-term working capital from commercial paper to factoring receivables. Short-term loans are quite common and are often secured. A common form of working capital loan is secured by the receivables owed to the company by its clients. All these short-term finances tend to have lower costs than long-term capital and, if managed right, can lower financing costs.
Trade credit is another typical form of short-term capital. In this instance a supplier may extend credit to a customer for a period, effectively financing their customers purchase for a short period. For example, an aluminum company, Alpha Corp., may deliver its raw product to a company that makes fenders for cars, Beta Inc. Instead of demanding payment immediately, Alpha Corp. may give Beta Inc. terms that state they have thirty days to pay them for the aluminum and if they pay within ten days they get a 3% discount on the price. This is known as 3/10 net 30. In many ways this was some of the original peer-to-peer lending, without all the technology. The internet has obviously opened many more avenues of short-term financing for companies in need of capital.
Government regulators are facing challenges in trying to keep up with all the new sources of financing, some of which they may not actually have jurisdiction over. They need to be careful not to choke off access to capital for newer business entrants just because they are getting capital from innovative sources. They do not want to create an uneven field benefitting incumbent companies over new ones. However, they do need to maintain order and fairness and prevent fraud from both those raising money and those offering to invest money.
From an investor point of capital can be an important tool to be used in measuring performance. Perhaps the first and most important rule for many investors is to preserve the initial invested capital. However, capital does not have a constant value. Some places that you invest capital you would expect to stay relatively constant, such as a savings account. Most other places you would put capital you would expect some greater level of asset value appreciation, like in buying a government bond or investing in a stock or even in a less liquid asset like buying a house. With a house you are hoping to get two forms of reward, you are getting utility from the use of the house and hopefully experiencing asset value appreciation.
Sometimes when you invest capital the expectation is the value will go down. For example, a common statement is that the value of a new car drops 10% the minute you drive it out of the lot. It is generally recognized that physical capital investments often decline through usage. In the case of a business that builds a new plant, it anticipates getting a return on the investment from the cash flow the plant generates. Studying how well a company deploys its capital and the type of returns it can get on this capital is an incredibly valuable tool to utilize in analyzing an investment and comparing the relative value of different investment possibilities. Unfortunately, while these return on capital calculations are valuable the methodologies tend to allow for a significant amount of subjectivity so when making comparisons it is key to strive for consistency.
When a company invests in a physical plant it is an asset and accounting rules will depreciate this asset over the expected useful life of the investment. Increasingly rapid innovation may cause the actual resale value of this invested capital to depreciate much more quickly than the accounting methodology, which means the stated book equity value of the company will not properly reflect the value of that asset. This is one of the reasons why, when it is possible, using the market value of a company is more valuable than the accounting “book” equity value. Many of the fastest growing and more innovative companies in the world are investing less in physical plant and in many cases are investing in less tangible assets (e.g., customized software, supply chain specs), which may have strong potential for cash flow generation for a specific company, but if a company was forced to sell its assets the specialization of these “soft” assets may limit the value they could fetch from other buyers. This could hurt the returns for investors if a company goes into distress.
Return on Capital—A Subjective Tool
Return on capital (ROC) measurements are a valuable tool to help measure how efficient a company is at making a profit from the capital they have raised or invested. In principal it is a simple concept. It is a measure of earnings divided by some measure of the company’s capital. A basic formula is:
It is a particularly good tool to use in examining capital intense companies, like oil and gas companies or utilities. However, the performance of this ratio should be analyzed over time, not just as a snapshot, especially when comparing companies.
Economic formulas often look complex but the concepts are simple; in finance the ratios often look very simple but the potential complexities are quite difficult. The ROC measure is such a case because as you try to make the formula more relevant for today’s world more subjectivity enters the equation and can bias comparisons and outcomes. We can examine some of the potential complexities of the ROC formula by looking at the possible issues with the numerator and do the same with the denominator.
On the numerator side of the formula, net income may not be the best measure. There could have been significant acquisitions or some other change in their assets, so depreciation does not match capital expenditures, or there may be certain one-time benefits or charges that make comparisons between companies difficult. As an alternative you may choose a measure that is more cash flow oriented such as earnings before interest, taxes, depreciation, and amortization (EBITDA) or just EBIT. You also may want to consider how to factor in decisions to deduct dividends or stock buybacks. All of these are nuances that can affect the analysis when you compare ROC ratios overtime for the same company or between various companies or projects.
On the denominator it may seem straight ahead, but there is the question of the value of using -book equity, especially in situations when new technologies may have reduced the value of the balance sheet assets. One option may be to use market value of equity or another measure like assets net of current liabilities. Another question to consider is how to account for any large portions of cash that is not being deployed in to the business.
Sometimes the ROC is compared to the weighted average cost of capital (WACC). This ratio uses the cost of a company’s debt and the cost of its equity on a weighted average basis. This ratio has its own very large issues of subjectivity. While the cost of any debt is easy to calculate, the cost of equity is very subjective as it technically has no explicit value. Typically, some form of expected return is usually used to value the cost of the equity and this then can incorporate a whole variety of methods and opinion.
Factoring in all these issues can take a fairly simple ratio and make it quite complex.
There are new, diverse and more rapidly available capital sources than in the past, but they may not be available to all companies. New industries are often deploying capital into less tangible assets and many of these companies have easy access to capital relative to incumbent businesses. If an industry experiences a new competitive threat and the threat is getting strong capital flows and the incumbent can not raise capital, the capital flows may prove to be a self-fulfilling prophecy of which will succeed and fail.
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