In business, the notion of an investment is a simple one – your company has committed a certain amount of money to a particular area in hopes of enjoying a return at a later time. This return can be directly monetary, as in the case of an investment in stocks. In that case, you expect to earn dividends off the money you’ve invested in the market and later reinvest or remove it. In other instances, the return can be less tangible, such as when your company purchases new equipment that will enable you to produce better merchandise and ultimately enjoy higher profits. These types of investments can be classified as either economic or financial investments.
What Are Economic Investments?
Economic investments are, by definition, additions to the capital stock of a company. These can range from equipment or machinery to a new production facility or even higher-quality materials to be used in manufacturing products to yield higher profit margins. The notion of capital stock just refers to something that is used in the production of other goods. Generally speaking, economic investments refer to a financial outlay in the areas of buildings, equipment and inventory.
Human capital is also included in the notion of economic investments. If your company brings on a new director of sales to help grow some of your accounts, you are investing in that individual, banking on their ability to bring extra profits to the business. As is the case with any investment, this effort might or might not prove fruitful, depending on how successful the director of sales is at her job.
Along similar lines, hiring 10 new employees to work on the production floor so that your company can begin to manufacture products on a night shift would be considered an economic investment. While initially the business will be forced to spend additional funds, you are moving forward under the assumption that the night shift employees will produce enough additional inventory to help you gain a bigger portion of the available profits in your industry.
Economic investments can, of course, be much more linear. If you purchase a second machine to shrink wrap your products, it will enable you to package twice as many in the same amount of time. This can help your business get more product out on trucks and into stores each day. Theoretically, this investment in the new shrink wrapping machine will help you produce more and increase your profits.
Even more direct is the relationship between the purchase of capital stock like inventory or machines that directly produce what you sell. With more ingredients on hand, your factory might be able to bake more cookies that you can then sell. With another industrial oven on the production floor, you should similarly be able to bake more cookies and thus see an increase in sales.
Keep in mind when considering economic investments that some capital stock necessitates an increase in other areas before profits can increase. Take, for instance, the example of purchasing more cookie ingredients. While this theoretically could lead to a spike in sales, you will also need to scale up your labor and sales channels to enjoy the profits you anticipate. Without additional staff to bake the cookies or stores in which to sell them, you could end up with extra inventory and nowhere to sell it.
What Are Financial Investments?
Financial investments are a bit different from economic investments. Whereas economic investments are tied to a tangible increase in capital stock, financial investments refer to an allocation of resources to assets that you expect to yield some sort of dividend over a period. Instead of being tangible objects or the means of production, financial investments are things like stocks, bonds or real estate ventures. Investments into the market, purchases of certificates of deposit or bonds, ownership of rental properties and even things like life insurance policies would fall under the category of financial investments. These investments merely transfer the existing ownership of an asset from one person or institution to another. Anything that you expect will yield financial gain in the future but is traded as a purely financial resource in the short term could be considered this type of investment.
Generally speaking, the more developed an economy or a company, the more likely it is to deal in financial investments rather than merely economic ones. Financial investments tend to come about when an entity has enough capital to spare that they can maintain the status quo and stay profitable, plus some. Without adequate financial stability to keep your company running, you likely won’t be looking to make as many financial investments. A bit of extra funding usually goes towards economic investments, to grow profits. Only once the company has managed to develop a stable system for maintaining the growth of economic investments do they tend to move on to financial investments.
Businesses often choose to invest in real estate as they grow. Successful retail chains, in particular, often make the bulk of their income from their real estate interests. This is a way to grow profits at a more rapid rate than other sorts of financial investments.
Why Businesses Need Economic Investments and Financial Investments
It’s important to the longevity of a business to have both economic and financial investments. Since these two types of investments overlap but are not the same, they can each offer a different form of stability to the company in the long-term. Starting largely with economic investments and then growing to also invest financially is a common trajectory for businesses.
Imagine the need for economic and financial investments on a personal scale to get a sense for why both are so important. As an individual, you need a place to live and a car to get to work. Both of these would be considered economic investments unless you are renting part of your home to another family to earn additional income. For a while, especially when you are first starting out, you might find that you only have enough money to afford your house and your car payments. Over time, though, as you move up the corporate ladder at work and find better ways to use your money, you might start to have a bit of savings. It’s at this point that many individuals begin to think about financial investments.
For a non-business entity, a financial investment might be the purchase of stocks, bonds or CDs. It might be the creation of an IRA or 401k, the purchase of a rental property or acquiring a new life insurance policy. Any of these financial investments can put you on a more stable trajectory for the future. When you diversify your assets and spread your capital among many forms of investment, you are far better protected in the event of a disaster, such as loss of a job or sudden medical crisis.
Economic and financial investments work much the same way for companies as they do for individuals. It’s imperative that a business has both sorts of investments to put them on a stable path and protect them from the many what-ifs of running a company. As soon as they are able, it’s wise for companies to begin to seek out financial investments, both to further grow their capital and also to put them on a more stable footing for the future.
There is a clear interdependence between economic and financial investments, as well. When you have financial investments that yield profits, those profits can be reinvested for economic purposes. As your company’s stock holdings pay dividends over time, you can use that money as a source of funding for new manufacturing equipment or an improved production facility. Similarly, economic investments like enhanced equipment can help you earn more profits, the overage of which can be invested financially for an additional gain down the line. If you are only making economic investments, it will be difficult to ever grow your company past a certain point. The same holds true for a business that only makes financial investments.
Benefits and Downfalls of Economic and Financial Investments
The major downfall to both economic and financial investments is the lack of assurance that they will pay off. While it is almost certainly the case that your business will enjoy some sort of dividend at some point from a balanced combination of economic and financial investments, there is no guarantee of this occurring.
When you invest in any way, personally or for your company, via the purchase of capital stock or assets like stocks and bonds, you are taking a risk. You believe that the chance of increased profits or the accumulation of assets as a result of your investment is greater than the chance that your decision will yield neutral or negative monetary results. In choosing to invest, you must acknowledge that either outcome is possible, and your company should be prepared to recover regardless of what transpires.
In the short term, the failure of economic investments to bear fruit can have a more direct impact on the profitability of your business. For instance, if you purchase that new industrial oven for your bakery in hopes of increasing production and driving sales and profits, you are taking a risk on an economic investment. You scale up to staff appropriately so that the industrial oven can constantly run and produce as many cookies as possible. You have your sales team work hard to get the additional inventory onto store shelves and in front of customers. Unfortunately, it may prove to be the case that you are unable to sell extra cookies. Despite your careful planning and market research, the area in which you distribute your products is saturated with baked goods and buyers aren’t interested in the extra inventory you have available. Since additional profits aren’t covering the economic investment of the new industrial oven, you will be at a financial loss.
The same could hold true of financial investments. Say your cookie business was doing very well and the board of directors decided to use some capital to purchase a new production facility, with the goal of scaling up and also using a portion of the new building as a rental, generating further profits. Once you’ve moved forward with the sale, you have a hard time finding anyone interested in moving into the new space for lease. The tenants you can find are not interested in paying what you would need to charge to turn a profit. Your financial investment in the new building, therefore, would be considered a financial loss.
In either of these scenarios, you would ideally only make one major investment at a time. Perhaps your failed economic investment of the new industrial oven came at a time when the company’s financial investments were doing quite well. Maybe sales were soaring when you bought the new building, so the lack of tenants proved less of a hit to your finances. These examples illustrate the importance of a balance of economic and financial investments, as well as how critical it is to make only some major business changes at a time.
The benefits of economic and financial investments are tremendous, in that each can lead to untapped growth potential for your company if executed thoughtfully and timed properly. A careful balance of each kind of investment is critical to achieving the ultimate in profits.