Financial Capital vs. Economic Capital: What's the Difference?

Financial Capital vs. Economic Capital: An Overview

Financial capital is the monetary assets required for a business to provide goods and services. Economic capital is commonly calculated through risk management strategies and determines the capital required to cushion a business from losses.

Financial Capital

Financial capital is a broader term than economic capital. Anything can be a form of financial capital as long as it has a monetary value and is used in the pursuit of future revenue. Financial capital is commonly viewed as debt or equity.

Types of Financial Capital

• Equity: Direct investment in a business is referred to as equity. When someone contributes $100,000 to a business in the hopes of receiving a portion of future profits, they increase its equity capital by $100,000.

• Debt: Sometimes a business decides to finance its activities through debt instead of equity. Debt capital does not dilute ownership nor entitle the creditor to a proportional share of future profits. However, debt represents a legal claim on borrower assets and is considered riskier than equity capital. Companies that cannot repay their creditors may face bankruptcy.

Economic Capital

Measuring economic capital is necessary for internal risk management and determines how much financial capital a business needs to cover potential future losses. Economic capital is a measure of risk, not of the financial or monetary capital held.

Economic capital lies outside common accounting and regulatory capital measurements. It is the difference between a given percentile of loss distribution and the expected loss.

• Expected Loss is the anticipated average loss over a defined period. Expected losses are expected to be absorbed by operating income. In bank loan losses, the expected loss should be priced into the yield, and an appropriate charge included in the allowance for loan and lease losses. 
• Unexpected Loss is the potential for actual loss to exceed the expected loss and is a measure of the uncertainty inherent in the loss estimate.
  
  

The Bottom Line

Financial capital includes the assets a business requires to deliver goods or services, such as money, credit, and other types of financing that corporations use to generate revenue. Economic capital measures the potential future losses for a business and calculates its capital adequacy. A good economic capital model aids risk management strategies and equips businesses to anticipate potential problems.