The word “capital” has many different meanings in economics and finance. Financial capital most commonly refers to assets needed by a company to provide goods or services, as measured in terms of money value. Money raised from debt and equity issues is normally referred to as capital. Economic capital is the estimated amount of money needed to cover possible losses from unexpected risk. A firm’s economic capital number can also be seen as a measurement of solvency.
In economics jargon, capital can also refer to the machines, factories and other tools used to create final, or consumer, goods. Capital goods are not directly sold for money, so they usually require elements of investment and risk to accumulate and use. This is distinct and separate from the type of economic capital described below.
Financial capital is a much broader term than economic capital. In a sense, anything can be a form of financial capital as long as it has a money value and is used in the pursuit of future revenue. Most investors encounter financial capital with respect to debt and equity.
Direct investment in a business is referred to as equity. When someone contributes $100,000 to a business in the hopes of receiving a portion of future profits, he increases its equity capital by $100,000. Corporations issue stocks, or shares of company ownership, in exchange for additional equity. Equity capital is not typically accompanied by a guarantee of future returns.
Sometimes a business decides to finance its activities through debt instead of equity. Debt capital does not dilute ownership and does not entitle the creditor to a proportional share of future profits. However, debt represents a legal claim on the assets of the borrowing company and is considered riskier than equity capital. Companies that cannot repay their creditors have to file for bankruptcy.
The concept of economic capital was initially developed as a tool for internal risk management. Economic capital answers the following question: “How much financial capital does the business need to cover potential future loss based on current risk exposure?”
Most companies use specific formulas for estimating their economic capital. The way to consider risks and the method of quantifying possible losses has changed over time. Some risks are easy, such as credit risk on a loan, where the exact amount of possible loss is stated in a promissory note and can be adjusted for inflation. Operational risks are more challenging; opportunity costs are even more difficult.
Once a company believes it has an effective model of calculating economic capital, future business decisions can be strategically made to optimize the risk/reward trade-off. However, this is easier said than done. Validating a model through backtesting only highlights its possible accuracy but can never completely prove it. There is also no guarantee that future conditions will mirror past conditions; significant deviations of variable relationships can render an otherwise well-built model as unsatisfactory.