One of the four inputs of the business system is capital. It is the job of financial management to obtain funds for business and to use them to get the resources which will produce a profit. This chapter explores the nature of capital, the need and sources for short-term credit, and the major banking institutions. We will present answers to the following questions: What is capital? Why are short-term funds needed? What ways are there for a company to obtain short-term funds? How does the Federal Reserve System work?
In remote parts of Alaska, some trappers and traders still make their living by trapping fur-bearing animals for skins to trade for money or goods. These men need little more than their clothing, traps, guns, and perhaps a horse, a few dogs, or a jeep. Yet simple as this equipment is, it illustrates the essential characteristics of business capital.
Every business, whatever its size or activity, must raise capital, produce goods or services, sell the goods or services, and dispose of the proceeds of sale. The Alaskan hunter must have, or borrow, enough money to buy his first outfit. He then traps animals and sells or trades them, and disposes of the proceeds in any of several ways. He may use most of the proceeds to buy more traps and equipment, or he may divert most of the proceeds to buy food, clothing, and housing for himself. He has to use some of the proceeds to live on, but he must also plan for the replacement of broken traps, horses that die, and hunting boots that wear out.
The problems of capital which the hunter faces are basically similar to those of IBM and General Motors: there are differences of magnitude and of physical characteristics, but not of fundamental character. It is the size and variety of operations of the large public corporation that makes its financial problems more intricate than those of the simple hunter. This and the following chapter take a look at the financing function of the business enterprise and point out some of the most important financial issues facing the corporation today.
We have seen that the modern corporation is formed in the hope of making a profit for its owners. To do this, it must first be endowed with inputs of management, labor, capital, and land. Capital represents the economic resources which the corporation devotes to making a profit. It is the wealth turned over to the corporation by its owners and others to enable management to carry out the purpose of the corporation. This view is in basic agreement with the economic concept of capital.
Other concepts of capital in the financial community are of specific use in understanding the financial operations of business today. The accountant’s concept of capital is founded on the need to have a common denominator for valuing the resources of a business. This common denominator is usually the original money value of a resource, regardless of its nature or its current value. Capital is conceived of as the money value of property owned by the corporation, whatever its sources or uses. One reason for equating capital with original cost is that costs are assumed to be verifiable, since they represent cash outlays and exchange value of goods and services at the time they were acquired: that is, evidence that they are worth to the firm just what they cost.
The accountant’s view of capital differs from the economist’s in that the account ant may include properties not presently used to earn profit, such as land held for future use. Besides, values change with time, and the cost of a property may not equal its present economic value. Money also changes in value. Since World War II, the United States has experienced fairly steady inflation. Property, products, and services purchased last year in last year’s dollars would cost more dollars if purchased this year.
Still a third view of capital is that of the businessman, who must take a pragmatic view of capital and look at the total properties and resources of a company from an overall systems point of view. The systems concept of capital is concerned not only with physical properties but also with human and intangible properties, and how all these work together. The human capital of an enterprise-its management and work force-maybe it’s most valuable property. But this fact usually does not show up in the analyses of economics or accounting, although both fields have made important studies of human resources in recent years. Intangible assets include basic rights a company possesses which may be worth far more than their original cost. Such rights include trademarks, patents, and copyrights, and such things as an ideal location, access to necessary supplies, or even the general reputation of the company. All these properties and resources must be put together in a system which works well. The productive potential of this system and how well it achieves this potential is the fundamental interest of business management.
In principle, the financial problems of great corporations are much like those of our lonely hunter. The corporation must raise capital, use it, and distribute the proceeds. Let us now look at the first two of these overriding financial problems of corporations.
An accountant’s balance sheet will help us see the nature and relationship of these problems of financial policy. In the accountant’s financial system, the sources and the uses of capital must by definition equal each other. The corporation is conceived of as the gathering of resources into a single fund dedicated to an economic purpose. As can be seen in, capital is provided to and used by the corporations in equal amounts.
The corporation is conceived in law, finance, and the social order as a separate and independent entity, and there must be a clear separation of what belongs to it and what does not. The origin of its property and the conditions under which it gets its resources must be clearly understood. The sources must be sharply delineated so that the rights of the contributors may be protected and they may share in success or failure proportionally.
There are three broad sources of corporate capital. First, there are the contributions of the owners of the enterprise or of capital stock. When a corporation is formed, and sometimes through later sales of capital stock, the owners are paid in money for shares of the ownership the amount of each contribution is represented by capital stock.
The second source of capital comes from operations. If the corporation makes money, the accumulated profit provides it with additional capital. If the corporation is unprofitable, its losses will reduce its capital. The directors of the company have the alternative of paying accumulated profits to the shareholders or owners, or of reinvesting them in more assets in the hope of earning more profit. Some very successful companies, especially in such fields as computers, electronics, optics, and drugs, have preferred to reinvest profits in research or in more assets in order to earn higher profits for their stockholders. Other large and successful companies, such as many in the utility industry, have preferred to pay much of their profit to their stockholders. In any event, the excess which is not paid to stockholders is added capital for the company. Taken together, the capital stock of a company and its accumulated profits are usually referred to as equity capital.
The third source of capital is debt, borrowing by the corporation with the understanding that repayment must be made by a fixed future date. Such financing is usually classified by the length of time before repayment must be made. Short-term obligations are those which must be paid back within one year; long-term obligations are debts due in over five years; intermediate are those due between the previous limits.
