Capital is assets invested into a business and the term describes the liquid assets available to spend. Generally, both fixed and current assets represent capital but stakeholders are more concerned about the continuity of the business using cash and assets that can be turned into cash quickly to pay liabilities and expenses.
The owner or shareholders may invest land, buildings and cash to start, expand or save a retail business in debt. The land and buildings are used to operate the business to generate income. However, the cash is readily available to pay for goods for resale, utilities, salaries and loan installments.
In the ledger, Capital or Equity account records an increase and has a credit balance. When it decreases, a Drawings account is debited to make the adjustment. On the Balance Sheet, the opening balance of the account subtracts Drawings to show Equity.
Types of Capital
Capital is classed under several titles. This information is important to stakeholders of a business because it breaks down how the assets are related to the liabilities. Here are some types.
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This is all the assets invested into a business that circulates for the business to achieve its objectives. It comprises cash and fixed assets contributed by shareholders, debt holders and lenders.
It is spread out in the first part of the balance sheet and is not shown as a separate line. It represents the combined value of equity and debt capital.
This measures liquidity of the business. It means it looks at inventory, prepaid expenses, debtors, cash in hand and cash in the bank against short-term loans, prepaid revenue, accrued expenses, and creditors.
Having cash and items that can convert to cash easily ensures that the business can pay salaries, utilities and rent every month. Working capital is current assets minus current liabilities and appears in the first part of the balance sheet.
This is the investments used to operate the business to generate profits. It shows how the business is investing its money. By employing capital, companies invest in the long-term future of the company.
A high return on capital employed is a great indication that the business is using its investments effectively. It is calculated as total assets minus current liabilities and appears in the first part of the balance sheet.
Equity represents the value of all fixed and current assets in the business if it was to be liquidated. The term covers everything that the business owns and tells stakeholders exactly what the business is worth if it was turned into cash.
This would occur if it sold its goodwill, land, buildings, motor vehicles, machinery and add it to its cash and cash equivalents. It is calculated as total assets minus total liabilities and appears in the second section of the balance sheet.
This is a short-term investment made by large investors to fund the plans of a small business or project. A start-up company may propose a very impressive business plan with the potential to be successful.
The business plan outlines the marketing, financial and operational steps to be taken to get the business off the ground, break-even and make a profit within a specific time frame. This investment goes in the equity section of the balance sheet.
This is the money a company raises by issuing shares. Authorised shares are the maximum amount that can be issued to stakeholders as agreed in its articles of association. Issued shares are the number of authorised shares that a company allocates to its shareholders.
Preference shares are held by stockholders who are entitled to be paid dividends before ordinary stockholders. Ordinary shares are also called common shares and each share gives its owner the right to one vote at a company shareholders’ meeting. These go in the equity section of the balance sheet.
Assets = Liabilities + Capital
Everything the business owns is equal to everything it owes and had invested.
Liabilities = Assets – Capital
Everything the business owes is equal to everything it owns minus what was invested.
Capital = Assets – Liabilities
Everything the business invested is equal to everything it owns minus what it owes.
These 3 headings in ALICE accounts appear in the balance sheet. Here is an example of how the accounting equation works.
1. An owner invests $200 cash.
2. Brings in a van worth $300.
3. Borrows $100 cash.
4. Buys a building for $200.
5. Deposits $100 cash in the bank.
Assets is $200 cash at start add $300 van add $100 cash borrowed minus $200 cash to buy building add $200 building = $600.
Liabilities is $100 loan = $100.
Capital is $200 cash at start add $300 van = $500.
Assets $600 = Liabilities $100 + Capital $500
Liabilities $100 = Assets $600 – Capital $500
Capital $500 = Assets $600 – Liabilities $100
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