Capital is one of the most fundamental concepts in finance and economics. It is also one of the most elusive. Karl Marx understood its importance when he introduced the words “capitalist” and “capitalism” in his writings. But what is capital?
According to classical economics, capital is one of the three factors of production, the other two being land and labor. It is not consumed either as an end product or through the production process, although it may depreciate over time. Unlike land, capital is itself produced. It is defined not by what it is but by how it is used. To a cab driver, his automobile is capital. To the average person who drives only for her own needs, an automobile is a consumable.
Most firms hold capital in the form of plants and equipment. Financial institutions are different. With little need for physical assets, they mostly hold capital in the form of financial obligations that serve as a “buffer” against possible losses arising from their financial activities. This assures customers, counterparties and regulators they can remain in business even in the event of large financial losses. Generally, the more risk a financial institution takes, the more capital it should hold.
The capital of a business can be measured in two theoretically equivalent ways:
- the sum value of capital invested in the firm, with adjustments for things like retained earnings or depreciation.
- the difference in value between the firm’s assets and liabilities.
For practical reasons, such computations tend to be done using book value, as opposed to market value, accounting. Because book values tend to be stable, reported capital is an incomplete portrayal of a firm’s economic health. For financial institutions, capital adequacy calculations and asset-liability management can provide alternative insight and help ensure a firm’s ongoing economic health.