The Capital employed in the business is not free

The Capital employed in the business is not free

 

Capital is the total of the financial resources in cash or kind available for use in business by the organisations. The capital is used to acquire fixed assets, and to provide for working capital.  Capital either in cash or in-kind is necessary in starting any business venture.  Capital is necessary to acquire equipment, engage labour, procure raw materials and implement processes necessary for proper management of the business.

Type of financial capital

The types of financial capital include the following;

Equity Capital

This is the net worth of the business that is total assets minus total liabilities and it belongs to the shareholders of the organisation.  The equity is contributed by shareholders and impacted positively or negatively over time by profits or losses respectively made by the organisation. This type of capital is the most favoured by organisations as it has no fixed return and payment period.

The working capital

 This is a difference between current assets and current liabilities of an organisation. The current assets are most liquid assets of an organisation including cash, stocks and debtors and current liabilities includes all liabilities which are payable within twelve months.

 Debt capital

 This is a capital which attracts fixed interest charges and has  fixed repayment terms. This is the most readily available form of capital on the market for both expansion and new or green field projects

 Cost of capital

 The cost of capital is the cost of the funds used by the organisation both equity and debt from the investors point of view. It is the return the investor expects from the investment.  The investor will therefore invest in the organisation if the organisation is offering a return at least equal to the expectations. In the case of equity capital with no fixed return, the cost associated cost is the opportunity cost in terms of loss of income and potential gain in case the equity capital was invested in other viable options outside the business.  Providers of capital whether debt or equity require a return on their capital invested into the business. Providers of equity capital demand dividends based on the performance and growth of the business.  Debt providers require fixed interest payment on their funds irrespective of the performance of the business. Debt providers do not have any claim on the surplus profit of the company. The amount of dividends or   interest expected by the providers will very much depend on the risk status of the business. The higher the risk the higher the return on capital expected by the providers.

 Importance of cost of capital

The cost of capital is important to the investors as it enables the investor to assess whether the business project they want to engage in is viable or not .The return on the project is assessed against the expected return the investor would have earned elsewhere. It is important to appreciate that the cost of capital has also an impact on the pricing of goods and services produced by the organisation. The cost of capital contributes to the cost of producing goods and services.  Expensive capital makes the goods and services expensive and in turn will affect the competitiveness of the business.

Author 

John Muhaise Bikalemesa

Director: Big Drum Advisory Services Limited

johnmuhaisebikalemesa@yahoo.com

 

About The Author

John Muhaise-Bikalemesa (JMB), is the founder of Muhaise.com blog and bigdrumassociates.com company. Learn more about him here and connect with him on his social medias below

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