In simple term, capital can be defined as the owners claim in the business. On the other hand, liabilities are debts which a business owes to external or internal stakeholders. According to accounting equation, liabilities are the difference between assets and capital.
We often expect that since capital is money which is used to start an enterprise, then it should be seen as an asset not but liability, but this is totally different in accounting. As we record the different type of capital in a company, they are found on the credit side and are categorized as a special liability.
Few years ago, while I was still teaching financial accounting in a secondary school, i was teaching the topic "trial balance" and I stated the rules of trial balance. I told my students that capital is a liability and should be recorded on the credit side of the trial balance.
A student told me that since it is the funds used to start a business, it should be an asset and not a liability and shown on the debit side. Although, i was expecting such statement from my students because I asked the same when i was a secondary school student too.
That encounter with my student was the motivation behind this article. I am writing on why capital is a liability so that people with similar opinion as my student will learn and understand why it is a liability, not an asset.
Why Capital Is Found On Liabilities Side Of Balance Sheet
Like i said earlier, using my student as an example, one of the most frequently asked questions is that even though capital is invested by the owner in the form of cash or assets, why is it recorded on the liabilities side of the balance sheet?
Now let me ask the big question again, is capital an asset or liability? From the accounting point of view, it is a liability because the company is obliged to repay its owner the funds which was invested to start and run the enterprise.
Assets = Liabilities + Capital/shareholder's equity
Here, I used the accounting equation to explain the shareholder’s equity/capital as a balancing figure between the company’s liabilities and assets. Since the capital invested into a business is used to settle all the debts incurred, therefore, it has a credit balance and hence, it is recorded on the liabilities side of the balance sheet.
Reasons Why Business Capital Is A Liability
1. Capital and the business entity are two different things
In business terms, the entity and capital are two separate things. Though capital is the money that the owner invested with the aim of making profit. The owner expects the money he invested into the business to earn viable returns and return both the invested funds and profit back to him. For small businesses, it is important to have enough working capital to take care of daily expenses such as payroll, inventory, and accounts payable.That’s why it is considered a liability and credited while preparing the books of accounts.
In the balance sheet context, capital is referred to as the obligations that an organization has to meet so as to source for the capital goods. In this case, it refers to the loan that the owner used from his personal funds to purchase inventories and later sell at a profit.
2. Capital and investment differs
Capital and investment are two separate terms that are often used interchangeably by people who think they mean the same thing. Capital means the sourcing of funds whereas investment means deployment of funds. Investment can be done in either short-term or long-term. Investment processes include purchasing and reselling of inventories for profit.
Thus, on the balance sheet, capital is shown on liabilities side while investment is shown on the assets side. Investment is a current asset or intangible asset depending on the classification you want to adopt. Most people see capital as an investment but that is false as we have seen that it's a special liability and not an asset as many people see it
3. The Owner Lends Money To His Business
Few years ago as an accounting student, we leant about the various accounting concept. There is a concept called the BUSINESS ENTITY CONCEPT. This concept states that a business organization is separated from its owners. It further explain that you can sue an owner without suing the business and vice versa, the assets of a company is different from the assets of the owner.
When starting a business, you need capital which can be in the form of anything that the owner contributes to start the business.
For instance, Mr James started an enterprise, let's say ABC limited with $1,000,000. Using the entity concept, Mr James and ABC limited are two different entities. Here, Mr James gave a loan of $1,000,000 to the his company to commence operations. The enterprise is expected to refund him over a period when they start generating revenue.
From my explanation above, the company took a loan from Mr James which is a liability and expected to payback. The owner's capital is considered as liability to firm as per business entity accounting concept.
Here we discovered that the owner could have used the money for other purposes but he decided to lend the money to the enterprise in the form of capital which he expects to earn feasible returns in few years. For that reason, capital forms a special liability. Although, it is different from other long-term or short-term liabilities.
Why Capital Is Internal Liability
1. Internal Liability
They are commitments which a business has to pay to internal stakeholders such as promoters (owners), employees etc. Examples are Capital, Salaries, Accumulated profits, etc.
2. External Liability
These are all commitments which a business has to pay back to external stakeholders i.e. lenders, vendors, etc. Examples are – Borrowings, Creditors, Taxes, Overdraft, etc.
From the explanations above, it is clear that capital is an internal liability as it is the debt which an enterprise has to pay to its owners (promoters).
What Are The 3 Types Of Capital?
When preparing budget, businesses should primarily focus on three types of capital, which are: debt capital, equity capital, and working capital. We will explain them briefly below.
1. Debt Capital
A company can raise capital to begin operations by taking up loans. This is known as debt capital, and it can be gotten via private or government sources. For popular companies, they can raise funds by borrowing from banks and other financial institutions or in most cases, issuing bonds. For small businesses without Goodwill, they can source for funds through loans from friends and family, online money lenders, credit card companies, and federal SME loan programs.
2. Equity Capital
Typically, there are three types of equity capital. The different types are: private equity, public equity, and real estate equity. Private and public equity often take the form of shares of stock in the company. However, the only difference between them is that a company raises public equity by listing its shares on a stock exchange whereas it can raise private equity among a closed group of investors.
3. Working Capital
This is the most popular among the rest. A company's working capital is regarded as its liquid assets available for financing the day-to-day activities of the company. We can calculate it through the formulas stated below:
- Current Assets – Current Liabilities
- Accounts Receivable + Inventory – Accounts Payable
Working capital measures the short-term liquidity of a company. On a specific note, it constitutes a company's ability to pay its debts and other financial obligations which are to be met within one year. We wrote a comprehensive article on the meaning of working capital and how to calculate it, you can check it out.
A brief difference between the three types of capital are:
- Working capital is the funds needed to meet the daily business operations and pay its obligations at the right time.
- Equity capital is used to finance business expansion. It is raised by issuing shares in the company, either publicly or privately.
- Debt capital means borrowed funds. On a company's balance sheet, the amount borrowed is the capital asset while the amount owed represents liability.
In summary, I explained why capital comes in liabilities side of the balance sheet. Capital is an Internal liability because an enterprise must repay the owners the amount of cash, goods, assets invested into its formation. It is also known as the claims of the owners against the Assets of the business. While you are preparing balance sheet, make sure you put capital on the liability side because it is a special liability.