- What Is Net Working Capital and How Is It Different From Gross Working Capital?
- How to Calculate Capital Asset Velocity
- What Is the Difference Between Capital Investment Decisions and Working Capital Management?
- How to Calculate the Primary Capital Asset Ratio for a Bank
- Liquidity vs. Solvency
- Financial Statement Functions
Capital is invested in a business with the expectation of a financial return. Capital can come from a number of different places -- either creditors or owners -- and may be liquid or illiquid depending on the company's operational needs. A company's liquidity is an important concern for investors because it speaks to the company's financial health and the ability to retrieve their investment in the event of business failure.
Fundamental to any successful business operation is the deployment of investment capital. Investment capital is the money that the business acquires from both its owners or shareholders and its creditors, in exchange for the promise of future earnings or interest. In accounting terms, invested capital is the sum total of the company's liabilities (capital invested by creditors) and the company's equity (capital invested by owners). Investment capital includes all forms of liquid capital that the company controls.
One type of investment capital is liquid capital. Not all investment capital is liquid -- only those assets that can be converted into other assets with minimal financial loss. An obvious example of liquid capital is cash, or cash equivalents, which can be immediately paid out to shareholders, creditors or vendors without significant time delay, capital loss or financing charges. Easily marketable securities -- such as stocks or bonds held by the company -- and receivables -- money owed to the company -- are usually considered liquid capital.
Investment capital that is not represented in liquid capital is considered a fixed asset. This is because the money placed into illiquid investments cannot easily be converted to other uses, so it remains "fixed" wherever it is allocated. Examples are assets held over the long-term, such as plant equipment, land and other large property. Fixed assets cannot be sold easily, or to sell them would result in a substantial loss of value. Fixed assets are usually subject to depreciation, or the gradual decline of their value resulting from long-term use.
Importance of Liquidity
The distinction between liquid capital and total investment capital is important to investors because the companies they own need access to easily convertible assets to engage in their business activities. A firm with too little liquidity may end up having to sell fixed assets at a loss or take on more debt in order to satisfy its obligations; a firm with too much may be underutilizing its investment capital and limiting its returns. Well-managed firms, and those who invest in them, seek a careful balance of liquid to investment capital.