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Understanding Capital: A Guide to Knowing Your Finances

By April 22, 2021No Comments

Increasing sales, improving customer service, developing your brand, and maintaining your bookkeeping. These are all seemingly mundane small business activities. If your company has employees, then employee relations adds another layer. Though it may seem mundane, these are all day-to-day activities that are vital to business operations. And without something called working capital, you wouldn’t even have the means to operate these core activities.

So what exactly is capital, and how does knowledge of working capital, capital receipts, and capital expenditures help make you a much wiser small business owner? Well, the answer starts with getting to know your business finances.

In this guide, we’ll cover 3 key aspects of understanding capital:

  • Working capital
  • Capital receipts
  • Capital expenditures

Understanding Capital: A Guide to Knowing Your FinancesWorking Capital: What is it and why is it important?

So, what exactly is working capital?

Working capital is a key financial metric that represents operating liquidity availability to a business, organization, or other entity.

Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills), and inventory, and its current liabilities, such as accounts payable.

Investopedia

Why it’s an important metric

Working capital is the funds available to your business for its day-to-day operations. Without it, you wouldn’t be able to stay afloat—let alone scale your business.

It’s also something that investors will look for upfront. Your working capital represents to investors how your company’s short-term financial health and liquidity look during assessment.

Liquidity is how easily the assets of a company can be sold off and converted into cash.

How to calculate working capital

There are two main ways to calculate your working capital:

  • Net working capital formula
  • Working capital ratio formula

To find out how much money you have readily available to meet current expenses, use the formula:

Net Working Capital = Current Assets – Current Liabilities

The Working Capital Ratio

As a small business owner, every interaction can turn into a networking opportunity. Whether you’re out for dinners with a friend, working at a coffee shop, or attending a conference, you never know who you might meet. Sometimes you may meet investors unexpectedly. When that’s the case, you might need a way to get a sense of where your business stands in this very moment.

Calculating your working capital ratio allows you to do just that.

The formula is:

Working Capital Ratio = Current Assets / Current Liabilities

Capital receipts

The concept of a receipt is obvious: it’s a written confirmation that a payment has gone through—whether it’s made by cash, debit, or credit.

Capital receipts are a little different though.

Have you ever owned a property where you operate your business? Any long-term assets vital to your business operations (and not easily converted into cash) refer to fixed assets. Property, Plant, and Equipment (PP&E) is a key example of fixed assets that are not easily liquidated. When you sell fixed assets, you’ll receive a capital receipt.

To fully understand these unique receipts, you should know:

  • The accounting equation (read more here)
  • The balance sheet (find out what this is here)
  • Debits and credits (understand them here)

What are capital receipts?

Capital receipts are funds that are not revenue in nature and lead to an overall increase in a company’s total capital. Because these funds come from non-operating activities, they’re not shown inside your income statement, but rather, inside your balance sheet.

They are non-recurring in nature, unlike revenue receipts, which can be used to create reserves. Capital receipts on the other hand cannot create reserve funds.

Revenue receipts neither create any liability nor cause any reduction in the assets of the government. Taxes received by the government, for example, unlike borrowings, do not create any liabilities for it.

— Business Standard

Capital receipts lead to the creation of liability (debt to be paid in the future) and a decrease in company assets (resources that lead to capital gain). These receipts do not affect the overall Profit and Loss (P&L) of your business.

Where do capital receipts come from?

A few common examples where you would receive a capital receipt are through the sale of fixed assets, issue of shares, or borrowing through loans, insurance claims, or disinvestments, to name a few.

But generally, your capital receipts will come from these sources:

  1. The sale of fixed assets, which are tangible or intangible property owned or controlled by your company. Fixed assets are not as readily liquidated (converted to cash) as other assets (such as a company bank account).
  2.  The sale of shares in the business, including both common and preferred stock. (Learn more about issuing shares for your business)
  3. The issuing of debt instruments to your business, such as a bank loan. (Read more on good debt vs. bad debt)

What are they used for?

Funds originating from capital receipts is through the financing of capital expenditures—also known as CAPEX. These receipts can help pay off existing debt or held as a reserve (of capital receipts) to finance future CAPEX/debt repayment. The next section will explain what CAPEX are in detail.

Capital expenditures

Understanding CAPEX is not only helpful for accounting purposes, but it can help position you exactly where you want to be in front of investors. In the case that they want to know your CAPEX or capitalization limit, you’ll want the answer ready.

CAPEX occurs when you purchase a significant new physical asset for your business. Big-ticket items like new office equipment, machinery to produce products, or property (like office or factory space) are three common examples.

Record keeping looks a little different

You do not record CAPEX as expenses in your accounting record. They’re recorded as fixed assets instead, like the PP&E assets that produce capital receipts discussed above.

Fixed assets are recorded in installments over the course of the useful lifetime of an asset.

Example

Let’s say your business recently purchased a set of furniture for your new staff for $10,000. If the expected useful lifetime of this equipment is 10 years, then you would charge $1,000 per year to your depreciation expenses account.

Recording regular expenses versus fixed assets looks different on a tax return. For this reason, you should record your capital costs in a different section than your typical business expenses during tax time.

Understanding Capitalization Limit

If your small business is at the point of incurring CAPEX, you likely should have a capitalization limit in place. This determines a threshold where a business expense becomes classified as a CAPEX.

Example

Scenario A: Let’s say you purchase a new furniture set for $1,999 and your capitalization limit is $2,999. In this case, you would record the expense as a CAPEX instead of a regular expense. This only holds true though, if you record the at the same time you made the purchase.

Scenario B: If the furniture set cost $2,001, then you would record the purchase as a fixed asset using the useful lifetime installments mentioned above.

Why is this important?

It all comes down to financial health and what an investor wants to see when examining your business. From an investor’s perspective, your CAPEX is typically worth examining with other businesses in your industry and in relation to your cash flow.

A well-maintained level of CAPEX from year to year looks good to investors, especially in the case of a more established company. If these levels decrease over time, investors may flag that your business is not investing enough in its own growth or simply not keeping up with market development or competitors. Either way, your CAPEX, its capitalization limit, are all financial details that you must be in the know.

Conclusion

As a small business owner, you already know the importance of boosting cash flow, knowing the basics of accounting, and gaining a deeper insight into your numbers. Understanding how working capital, capital receipts, and CAPEX work together is just another piece of the financial puzzle. But it’s definitely one worth knowing—especially if you’re looking to connect with investors.

Though capital is only a portion of accounting, there’s a whole lot more to it. With TrulySmall Accounting, tracking your business income and expenses (including capital expenses) is automated and efficient. Our Chart of Accounts is completely flexible for you and your accountant to view and edit, and you can easily view and export the key reports that we talk about in this guide: the Balance Sheet, P&L, and more. Try it today with our 14-day free trial to see how it can make your regular bookkeeping (and tax filing) that much more efficient, particularly when CAPEX is involved.

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