Importance of Capital Formation

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No single business can survive without making investments into their future. Within a business, there’s always a need to plan for future growth and wealth; this requires investment in capital, the assets that are used to create a business’ value.

What is Capital?

For businesses who operate in production, capital normally refers to the physical assets that are used to produce the product; this could be machinery, plant equipment, facilities, and so on – the things that are used to make the product, but are not consumed in making that product (like raw materials). Even small businesses that are nothing like a factory still use certain physical assets to create their product – for a baker, the oven is capital; for a seamstress, the sewing machine. The difference between capital and other assets (like, for example, cash) is that capital assets are continuously creating value, or revenue, for the business on an ongoing basis.

The term capital can also be used to describe financial capital, which refers to a collective amount of cash, bonds and stock that are purchased and sold to create revenue. This definition is mainly used for businesses in which these particular intangible assets are the “product” providing the revenue stream.

Why is Capital Important?

Capital is a measure of physically quantifiable things, but the act of increasing capital requires an actual growth in the company’s money and savings, and then a reinvestment of that money into the company capital itself. This is why capital is so important to a business’ success: it represents the reinvestment of profits or revenue back into the business. This keeps that business’ physical assets in working condition, such that they can continue to create revenue, and opens up ways to expand or improve in the future to further increase revenue. It’s a company’s way of ensuring their company will continue to operate at the current level or greater; it’s a sign that the business’ future is being planned.

For example, a company producing a particular item may have two production lines. The item sells well, and revenue is high, so the company makes the decision to reinvest those earnings into capital, and makes plans to purchase a third production line. This ties up a lot of the profit into the construction and installation of the new production line – and, for a publicly owned company, may affect the returns given to the shareholders – but the creation of a third line will be able to produce more profit in the future. The third line is the new physical asset, and the goods that it will produce are expected to create future revenue.

Risks of Capital

There is, of course, risk involved with capital investment – just like there’s risk inherent in financial investment, such as the stock market. In the example above, the risk is in the assumption that the market will remain the same and the good being produced will continue to bring in revenue. The goal is to have the investment speak to both employees and shareholders in a way that says the business is committed to increasing future profits.

Capital investment is continually required because of depreciation – a financial measure of the normal wear and tear on existing equipment. At some point, the equipment will reach the end of its useful life and require replacement. If no capital is available, the company’s profits will suffer.

Capital Formation and Economic Growth

There needs to be a way to measure the growth of capital assets as money is reinvested. Capital formation, in economics, is the term used to capture the net change (typically, gain) in a defined accounting period. This includes increases in fixed assets, such as the purchase of machinery, equipment, facilities and so on, as well as the increase in the more intangible financial assets like stock. As it’s defined by the specific accounting period, capital formation in economic development is the accounting term for measuring the results of this reinvestment cycle.

Capital accumulation is a similar term, sometimes used interchangeably with capital formation and sometimes used to designate the process, rather than the accounting definition. Capital accumulation is the action of increasing a business’ assets using investments and profits, the drive being increased wealth, revenue and/or profits. With a manufacturing company, capital accumulation covers things like equipment replacement and improvement, opening up capacity via new production lines, improved facilities and the like. For companies dealing with intangibles, this might be a new investment, meant to give higher returns.

Estimating Potential Growth

When looking at the value added, most businesses separate physical capital (equipment and facilities) from financial capital (investments, debt, equity) in order to better estimate the potential growth obtained from an investment in physical capital. Financial capital can be tricky to predict, as it depends on interest rates and frequently changing markets to bring in the expected additional profit.

The main goal of investing in capital is to boost output, leading to a boost in profit. To examine the value of capital investment, however, one needs to consider the effect of that capital investment alone, all other things remaining unchanged, including labor, manpower and other technologies.

Using the example above, it raises the question: will that new third line increase the output proportionally? Will the company see the expected growth? There’s the chance that introducing that third line will cannibalize workers from the first and second, meaning overall output might increase, but efficiency might decrease.

Economic Growth and Capital

Capital accumulation for a business, a company or even a country, can lead to economic growth. More capital accumulation means faster growth, meaning a faster route to higher profit. These terms are often used on a national scale, to examine how developing nations can use capital to "catch up" with developed nations, and that a developing nation can get more out of the same amount of capital than an already developed nation will, due to the different levels of development.

This holds true when looking at companies as well: a new manufacturing company can use their capital on top-of-the-line facilities and equipment, while a manufacturing company that’s been around for decades won’t see the same benefit out of an equivalent amount of capital, as they’re limited by an already established system. It’s the growth of technology that allows less-developed companies, businesses and countries to take advantage of this.

Importance of Capital

Capital investment helps grow an economy in a few ways. First, investing in physical capital will create work for companies and workers who specialize in design, fabrication and installation of whatever new equipment is being added. This helps stimulate the local economy. Once the physical capital has been installed and is running, this can create additional jobs, as well as the boost that the increased output of goods will provide to profits.

The importance of capital in any economy – a small business, a large corporation or a nation – cannot and should not be overlooked. Some portion of profit needs to be reinvested back into the system in order for a business to survive. It’s a cycle for any company: making a profit, then reinvesting profit into the business to create more profit in the future.

No single business can survive without making investments in its future. Within a business, there’s always a need to plan for future growth and wealth; this requires investment in capital, the assets that are used to create a business’ value.

References

About the Author

Danielle Smyth, MS, is a writer and content marketer from upstate New York. She has been writing on business-related topics for nearly 10 years. She owns her own content marketing agency, Wordsmyth Creative Content Marketing (www.wordsmythcontent.com), and she works with a number of small businesses to develop B2B content for their websites, social media accounts, and marketing materials. In addition to this content, she has written business-related articles for sites like Sweet Frivolity, Alliance Worldwide Investigative Group, Bloom Co, and Spent.