What Is Borrowed Capital?
Borrowed capital consists of money that is borrowed and used to make an investment. It differs from equity capital, which is owned by the company and shareholders. Borrowed capital is also referred to as "loan capital" and can be used to grow profits but it can also result in a loss of the lender's money.
Key Takeaways
- Borrowed capital is money that is borrowed from others, either individuals or banks, to make an investment.
- Equity capital is owned by the company and shareholders and is the opposite of borrowed capital.
- Borrowed capital can take the form of loans, credit cards, overdraft agreements, and the issuance of debt, such as bonds.
- The interest rate is always the cost of borrowed capital.
- Increased profits can be obtained through the use of borrowed capital but it can also result in the loss of the lender's money.
Understanding Borrowed Capital
Businesses need capital to operate. Capital is wealth that is used to generate more wealth. For businesses, capital consists of assets—property, factories, inventories, cash, etc. Businesses have two options to acquire these: debt financing and equity financing. Debt is money that is borrowed from financial institutions, individuals, or the bond market. Equity is money the company already has in its coffers or can raise from would-be owners or investors. The term "borrowed capital" is used to distinguish capital acquired with debt from capital acquired with equity.
There are many different borrowing methods that constitute borrowed capital. These can take the form of loans, credit cards, overdraft agreements, and the issuance of debt, such as bonds. In all instances, a borrower must pay an interest rate as the cost of borrowing. Typically, debt is secured by collateral. In the case of a home purchase, the mortgage is secured by the house being acquired. Borrowed capital may also take the form of a debenture, however, and in that case, it is not secured by an asset.
Borrowed capital is commonly used in the economy whether that be for personal reasons or for business reasons. According to a Congressional Research Service report from 2019, almost 80% of small businesses in the U.S. relied on borrowed capital to operate their businesses. In 2018, small business loans amounted to $632.5 billion.
The upside of investing with borrowed capital is the potential for greater gains. The downside is the potential for greater losses, given that the borrowed money must be paid back somehow, regardless of the investment's performance.
Example of Borrowed Capital
To use an example from personal finance, when a person buys a home they typically make a down payment. The down payment comes out of their own wealth; their savings or proceeds from the sale of another house. If a home costs $300,000, their down payment would be $60,000, which is a 20% down payment; standard in the United States. The remaining cost of the house, $240,000 ($300,000-$60,000), would need to be borrowed.
The additional funds needed to purchase the house would come in the form of a mortgage loan from a bank. So, the house, which is now an asset belonging to the homeowner, is acquired with both equity and debt, or borrowed capital, in the form of a mortgage. The cost to borrow the $240,000 would come with a monthly interest rate that the homeowner would need to pay in addition to the principal installments of paying back the loan.
FAQs
The term "borrowed capital" is used to distinguish capital acquired with debt from capital acquired with equity. There are many different borrowing methods that constitute borrowed capital. These can take the form of loans, credit cards, overdraft agreements, and the issuance of debt, such as bonds.
What is an example of a loan capital? ›
Examples of loan capital include: Bank Loans: A company may borrow from a bank, agreeing to pay back the principal along with interest over a specific period. The interest rate could be fixed or variable.
Which is an example of borrowed funds? ›
Borrowed funds are funds that a firm borrows from outside sources to give capital to the company. This fund is distinct from the money invested in the firm, known as equity funds. Loans, bonds, overdrafts, and credit cards are all examples of borrowed money.
What is debt capital with an example? ›
Debt capital is the capital that a business raises by taking out a loan. It is a loan made to a company, typically as growth capital, and is normally repaid at some future date.
What uses borrowed capital for an investment? ›
Leverage refers to using debt (borrowed funds) to amplify returns from an investment or project. Companies can use leverage to invest in growth strategies. Some investors use leverage to multiply their buying power in the market.
What is meant by borrowed capital? ›
Borrowed capital is money that is borrowed from others, either individuals or banks, to make an investment. Equity capital is owned by the company and shareholders and is the opposite of borrowed capital.
What is the simple example of capital? ›
The capital assets of an individual or a business may include real estate, cars, investments (long or short-term), and other valuable possessions. A business may also have capital assets including expensive machinery, inventory, warehouse space, office equipment, and patents held by the company.
How to calculate borrowed capital? ›
How is borrowed capital as a percentage of capital employed measured? This is the firm's total borrowed capital, divided by its total capital employed. It can be calculated using information found in a company's annual report (10-K form).
What is borrowed fund in simple words? ›
Borrowed funds. Borrowed funds are referred to as the funds that a business needs to borrow from outside the company in order to provide a source of capital for the business. These funds are different from the capital owned by the company which are called equity funds.
What is the difference between owner's capital and borrowed capital? ›
The Owner's Funds are not backed by any security of any asset. The Borrowed Funds are backed by the security of assets. The reward for Owner's Funds is the dividend that they get at the end of a year. The reward for borrowers funds is the fixed rate of interest that they get at the end of a year.
Debt Capital is the money that a company raises through borrowing from individuals or institutions, and they must repay the entire amount after a specific time interval. They are a cheaper and low-risk alternative for getting finances when compared to equity capital. Debt Capital is either secured or unsecured.
How is debt capital used? ›
Debt capital refers to borrowed funds that must be repaid at a later date. This is any form of growth capital a company raises by taking out loans. These loans may be long-term or short-term such as overdraft protection. Debt capital does not dilute the company owner's interest in the firm.
Is debt capital good or bad? ›
Debt financing can be both good and bad. If a company can use debt to stimulate growth, it is a good option. However, the company must be sure that it can meet its obligations regarding payments to creditors. A company should use the cost of capital to decide what type of financing it should choose.
What is another name for borrowed capital? ›
Borrowed money can also be called debt capital or loan capital. Also read: Difference Between Fixed Capital and Working Capital. Intangible Assets.
Can you borrow money from yourself? ›
Also referred to as a share-secured or savings-secured loan, passbook loans allow you to borrow against your own savings. Acting similarly to a secured personal loan, your savings account acts as collateral, which means that if you default on the balance, your savings could be seized to repay the delinquent balance.
Can you borrow against your own money? ›
Basically, a passbook loan is a loan you take out against yourself. You are borrowing from your bank or credit union using your savings account balance as collateral. A passbook loan uses the balance of a savings account as collateral, which makes it lower risk for a lender.
Is loan capital the same as a loan? ›
Loan capital is like the total amount a company has borrowed altogether. It's the sum total of all the money they owe from different loans. Loan stock, on the other hand, is a specific type of loan.
Is loan capital a current asset? ›
The primary factor determining if a loan is considered a current asset depends on when it needs to be repaid, rather than when it is received. If the loan needs to be repaid within one year, then it will be classified as a current asset.
What are the characteristics of loan capital? ›
Key characteristics of loan capital include: Borrowed Funds: Loan capital represents funds borrowed from external sources, typically in loans or bonds. Interest Payments: Borrowers are required to make periodic interest payments to the lenders as compensation for using their funds.
Is loan capital a bank loan? ›
Loan capital comprises all the longer term borrowing of a company such as: permanent overdrafts at the bank.
