Capital is one of the core ideas of investing. In a nutshell, it’s anything that a company owns, that it combines with labour, to create whatever it is that it sells to its customers.
Capital can take all kinds of forms. For example, if you owned a factory, you would have a few different kinds of capital:
The land the factory is built on
The equipment in the factory
The building on top of the land
The same is true for any other business. A freight company’s capital might take the form of trucks, trains and ships. An airline’s capital would include airplanes. A power generator’s capital would include its electricity plants, and a lines company’s capital would include the lines it uses to transmit power to peoples’ houses. This means that capital is really important - the more capital a company has, the more potential it has to grow.
But when a company raises capital, it doesn’t go out and ask for airplanes, ships or power plants. Rather, it looks for money, which it then spends on these things. Let’s get into the details of how this happens:
Where the money comes from
Capital usually starts out as cash. Companies raise it in a bunch of different ways, but the main ones are:
A company issues shares for the first time, in an initial public offering (IPO)
A company that is already listed, issues some more shares
A company borrows money
A company reinvests profits
All of these end up with the same outcome: the company gets cash that it can turn into capital.
But why does this matter? Why does a company need to raise money, rather than just save up for a rainy day?
Where the investments go
When companies raise money, they generally do so to grow the business by investing in more capital. This is not that different from the way an individual invests to grow their wealth. Where you might buy shares, bonds or put your money in a savings account, companies invest in much more specific, complicated things. For example:
A company that makes physical goods might open a new factory
A company might expand into a new region
A company might create a new product
A company might hire more people
One good example is the Port of Napier IPO, where the port listed on the NZX in order to raise $150m to pay for a new wharf. Rather than save up $150m (which would have taken years), the port sold shares in itself in order to get started on construction right away. This means the port can get access to more wharf fees (parking fees for ships) faster, rather than wait years to save up the money.
As another example, Apple and Google have large amounts of cash that is essentially just sitting in bank accounts. That’s because they have so much, they don’t know what else to do with it! This is pretty rare—most companies have all kinds of ways to invest their money in order to grow.
Different levels of risk
Of course, this doesn’t mean the companies with the most capital are guaranteed winners. Just like the investments individuals make, the investments companies make come with risk.
For example, last year, a big insurer called CBL went into receivership (another word for bankruptcy). It had just raised money through an IPO a few years before that, but it stretched itself too thin investing that money—and now it’s not only in receivership, it’s also being sued.
No matter what a company invests in, the underlying principle is the same: a company with more capital available can invest in more growth than companies with less capital.
How to apply this
You can apply this thinking in your investment decisions when you’re doing your due diligence. If a company is raising capital, you can do some digging to find out why it’s doing so. For example, Tower Insurance raised $47 million from existing shareholders by selling shares. This money is to buy a smaller insurer called Youi NZ, and “strengthen its capital position,” which basically means putting money aside for a rainy day.
If you were considering this investment, you could ask yourself whether you think those are good investments. Do you think they’re high risk or low risk? What kind of returns do you think they’ll give you? In general, do you think this is a good use of your money?
When you’re looking at how companies use capital, it’s useful to think of them as investors like you, just at a larger scale. Like you, companies need to find money, take risks, and understand those risks. Then it’s up to you to decide whether you want to take part or not!