How Does Capital Formation Work
Capital formation works by diverting saved assets and converting them into different types of capital. For example, a city running on a budget surplus could use that surplus money to buy new public buses or to fund a new homeless shelter. Or an imaginary mining company could convert their profits into new, specialized mining tools.
For capital formation to work, some present consumption has to be forgone in the aim of funding projects down the line. Like at the individual level, entities like companies and governments have to use self-control and planning to afford to invest in real capital. Globally, the World Bank measures capital formation with a stated goal of ending extreme poverty.
The Importance of Capital Formation
Capital formation is directly tied to a company’s ability to compete in its industry. Without the various types of capital, a business is limited in its ability to react to market forces and adjust accordingly. Thus, companies that plan on growing and expanding need to have a clear understanding of capital formation in reference to their goals.
Three Stages of Capital Formation
Creation of Savings
The creation of savings is an increase in the volume of real savings for a given entity like a business or government. Much like on an individual level, companies and governments have to save in the present to use in future projects.
Mobilization of Savings
Mobilization of savings describes the process by which savings from individuals and households are transferred to entities who need the funds for investment. These entities include private companies and governments, among others.
Investment of Savings
Lastly, the savings accumulated can finally be invested into capital. Once this process is finished, the creation of savings can begin again and the capital formation cycle continues.
Two Forms of Capital Formation
Equity refers to the value that shareholders would receive if a company liquidated all assets and paid all debts. For investors, equity represents a form of residual ownership in a company. Companies can use equity as a means to raise short-term capital.
Debt refers to a less stable but increasingly popular form of capital formation. Through debt, companies can promise investors a certain amount of value in the future in exchange for immediate capital. Debt capital can come in secured and unsecured forms.
Learn More About How We Can Help
If you want your business to succeed in the current economy, you have to have a solid plan to raise capital. MPA can help you craft a capital formation plan based on equity, debt, or a hybrid securities package. Give us a call today to begin raising capital for your business endeavors.