Financial Capital vs. Economic Capital: An Overview
Financial capital is the monetary assets required for a business to provide goods and services. Economic capital is commonly calculated through risk management strategies and determines the capital required to cushion a business from losses.
Key Takeaways
- Financial capital is the monetary assets required for a business to provide goods and services.
- Economic capital is the capital needed to cover the company in case of loss.
- Financial capital is commonly viewed as debt or equity.
Financial Capital
Financial capital is a broader term than economic capital. Anything can be a form of financial capital as long as it has a monetary value and is used in the pursuit of future revenue. Financial capital is commonly viewed as debt or equity.
Types of Financial Capital
- 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, they increase its equity capital by $100,000.
Corporations issue stocks, or shares of company ownership, in exchange for equity.
- Debt: Sometimes a business decides to finance its activities through debt instead of equity. Debt capital does not dilute ownership nor entitle the creditor to a proportional share of future profits. However, debt represents a legal claim on borrower assets and is considered riskier than equity capital. Companies that cannot repay their creditors may face bankruptcy.
Economic Capital
Measuring economic capital is necessary for internal risk management and determines how much financial capital a business needs to cover potential future losses. Economic capital is a measure of risk, not of the financial or monetary capital held.
Economic capital lies outside common accounting and regulatory capital measurements. It is the difference between a given percentile of loss distribution and the expected loss.
- Expected Loss is the anticipated average loss over a defined period. Expected losses are expected to be absorbed by operating income. In bank loan losses, the expected loss should be priced into the yield, and an appropriate charge included in the allowance for loan and lease losses.
- Unexpected Loss is the potential for actual loss to exceed the expected loss and is a measure of the uncertainty inherent in the loss estimate.
What Is Confidence Level?
Confidence level is used in conjunction with economic capital in banking. The confidence level is established by bank management and is the risk of insolvency. The higher the confidence level, the lower the probability of insolvency.
Why Do Businesses Focus on Risk Management?
All businesses face the risk of loss to their capital and investments. If and when a risk becomes a reality, a well-prepared business can minimize the impact on earnings, lost time and productivity, and negative impact on customers through risk management strategies.
What Is the Difference Between Financial Capital and Venture Capital?
Venture capital is a type of financial capital and private equity financing investors provide tostartupcompanies and small businesses believed to havelong-term growthpotential.
The Bottom Line
Financial capital includes the assets a business requires to deliver goods or services, such as money, credit, and other types of financing that corporations use to generaterevenue.Economic capital measures the potential future losses for a business and calculates its capital adequacy. A good economic capital model aids risk management strategies and equips businesses to anticipate potential problems.
