Today the word capital is everywhere. When we were young we were instructed to start a sentence with a “capital” letter. We learned that a capital defined the more important city in a region or country. As such, capital demonstrated importance.
In business contexts today, capital is the fuel and the engine of an economy. Capital is accumulated as financial sources and deployed economically in concert with land and labor to create production outputs. This view connotes a “physical,” asset-driven motion of capital. However, capital has reached an inflection point. Capital in concert with foundations such as Human, Social, and Knowledge illustrates a commitment to accumulate and deploy in “non-physical” kinetic motion.
A dictionary reference views capital in the following ways:
– Wealth, whether in money or property, owned or employed in business by an individual, firm, or corporation
– An accumulated stock of such wealth
– Any form of wealth employed or capable of being employed in the production of more wealth
– Any source of profit, advantage, power, etc.
– An asset or assets (usually in combination)
Capital is in motion. The journey is purposeful. From financial source generation, capital seeks value. Value in this context is the fair return or equivalent in goods, services, or money for something exchanged. It is a business maxim, a creed, and a responsibility of decision making. “Use the capital and return with value” is a battle cry of capitalism.
So why has the word capital deviated from the physical to become omnipresent in business terminology today? Could it be possible that capital has a parallel important role in the search for value?
Capital resources are released into the business from sources derived from excess profits, borrowings from debt, and investor infusion for stock ownership. As resources, financial capital is deployed in long term investments such as a new Coca-Cola manufacturing plant, expanding cloud technology at Proctor & Gamble, or increasing the truck fleet at Amazon. In the short term, “working capital” ensures that there is funding to meet short term asset and obligation commitments from daily transactions. In each instance, these assets become part of the balance sheet focused on future economic benefit.
To measure value, short term capital is optimized through lower borrowing costs. For long term investments, value is measured in terms of a return on investment calculation. The investments that create specific revenue generation, cost optimization, or excess cash flow creation are determined to deliver a high return on investment or value.
However, in areas such as human, social, and knowledge capital, the classification as assets on the balance sheet is not an option. Capital resources in these important, nonphysical areas are treated as expenses in the current income statement. This financial accounting treatment draws on a contradiction to the word “capital” that connotes an accumulation of resources for future economic benefit.
Human capital is improved with capital commitments to improving employee performance through continuing education, healthy living programs, and teaching and coaching decision-making processes. The result is additional output growth in productivity and critical thinking to deliver dynamic solutions to a changing marketplace.
In social capital, a commitment to extending the cultural aspects of community, relationships, social networks, and mutually beneficial reciprocity builds on personal and professional strengths. The result again is additional output growth.
According to the OECD report “New Sources of Growth Knowledge-Based Capital,” an identification of assets that create future benefit for a company are not just “physical.” Drawing on three classifications, the OECD Report forms a mechanism of created output growth in the areas of computerized information, innovative property, and economic competencies. These focused categories have focused value capture. A better understanding of consumer needs from database capture, new engineering product designs, and improved consumer trust through brand building are the result of knowledge-based capital in motion.
The balance sheet is the foundation of the capital structure of an organization. As such, significant strategic planning and execution is involved to ensure that capital is deployed for value in both short- and long-term deployments. Balance sheet management is a priority to shareholders. Value is delivered through profits, which creates capital appreciation in the share price and an opportunity for dividend payments or stock buybacks.
Management of current assets, liability management, and long-term investing become a prism to ensure that capital results in value through decision making. This approach exposes short-term decision making of the operations of the business, the income statement, to maximize profits. The goal of profit maximization thwarts efforts to accumulate nonphysical asset capabilities in the areas such as human, social, and knowledge capital as fuel to productive growth. This occurs since investments in these nonphysical areas results in expenses and in turn reduces profit.
There is a disincentive to spend on marketing-based capital as the financial decision making of $100M versus $80M would always default to the short-term profit impact of spending $20M less.
A better understanding of consumer sentiment, needs, and communication of quality as an attribute will cap a resource deployment to a level of short-term profit maximization. An investment in an employee’s skill growth will be evaluated in the short-term from a productivity and output perspective, versus an acquired improvement in decision-making and business processes for long-term value to the organization. Return on investment calculations for these types of capital deployments on nonphysical assets must be rethought to achieve the benefits of short- and long-term decision-making value responsibilities.
It is incumbent of all professionals to understand capital, its desire to accumulate, it commitment to seek value, and its sometimes elusive ways to avoid its long-term blossoming in the spirit of short-term interest. Putting accounting record keeping in the context of reporting compliance of both the balance sheet and the income statement with the commitment to stay a true course for long-term value can move the dialogue of decision making in boardrooms, factory floors, and office interactions.
So be responsible with capital. Seek to accumulate capital for the right resources. Deploy the capital in physical and nonphysical opportunities. Keep value as your treasure map and measure diligently in each journey.
Written by Tony Poidomani, Financial Accounting Lecturer at Northwestern Medill IMC
Edited by Yue Liu, Medill IMC Class Of 2018