Before you start
You will be able to
- Define capital and distinguish debt from equity by the claim each gives, the risk each carries and what each costs a business in principle.
- Explain why debt magnifies the returns to shareholders in both good years and bad.
- Distinguish the liquidity of an asset from the liquidity of a firm, and liquidity from solvency.
- Calculate working capital, the current ratio and the quick ratio, and interpret what they do and do not show.
- Assess the liquidity of a person or a small business, including Ana’s emergency fund.
Review first
- What finance is: money, time and risk — You need the idea that people who provide money expect to be paid for waiting and for bearing risk.
- What a balance sheet is: a list of what a business has (assets), what it owes (liabilities) and the owners’ share (equity) at one date. This lesson explains the parts it uses; F01 Introduction to Financial Accounting covers them in depth.
Fictional case A fictional coffee business founded by Ana Lim. It starts as a catering and barista-training service, opens its own cafés and an online shop for beans, and plans a canned cold brew.
The idea
Fictional case
It is January 2026. Ana Lim, a head barista trainer earning $52,000 a year, has $26,000 in a Coastline Bank savings account that pays 1.5% a year. She plans to leave her job and open Lantern Coffee Co. on 1 March. Her plan has two money questions in it. First, where will Lantern’s money come from? Ana will put in $20,000 of her savings in exchange for shares, and Coastline Bank has agreed to lend the company $10,000 for two years at 6% a year. Second, once the money is spent on equipment and supplies, will Lantern, and Ana herself, be able to pay the bills that arrive each month? She will keep the remaining $6,000 of her savings as an emergency fund, because from March she will have no salary.
Those two questions have names. The first is about capital: the money that investors supply to a business so that it can buy what it needs to operate. The second is about liquidity: having, or being able to raise quickly, enough cash to pay what is due. This lesson gives you the vocabulary for both and the three calculations professionals reach for first.
Capital: the money a business runs on
In everyday speech “capital” can mean many things, from a city to a letter of the alphabet. In finance it has two related meanings. Financial capital is money supplied to a business by investors who expect something in return. Physical capital is what that money buys: machines, buildings, vans, computers. Lantern’s financial capital is the $30,000 that Ana and the bank provide; its physical capital will include the $12,000 espresso machine and grinder it buys on 3 March. When finance people say a firm is “raising capital”, they mean the first.
Financial capital comes in two basic forms, and the difference between them runs through the whole of finance.
- Debt
- Money borrowed under a contract that promises the lender payments set by the contract: interest for the use of the money and repayment of the amount borrowed, the principal, on stated dates. The lender does not own any part of the business. If the business misses a promised payment it is in default, and the lender can take legal action to recover what it is owed. Bank loans and bonds (debt securities sold to investors, which Investor.gov likens to an IOU) are the main forms.
- Equity
- Money invested in exchange for ownership. Shareholders own the business and vote on major decisions, but nothing is promised to them: they are paid dividends only if the directors decide to pay them, and if the business is wound up they receive only what is left after every lender and other creditor has been paid. That leftover claim is called a residual claim. In exchange, there is no limit on how much they can gain if the business does well.
Lantern’s capital on 1 March 2026 is dollars: $20,000 of equity from Ana and $10,000 of debt from Coastline Bank. The debt is one third of the total (). The bank’s contract fixes what it will receive: interest of dollars a year, paid as $150 every three months, and its $10,000 back on 1 March 2028. Ana’s contract fixes nothing. If Lantern thrives, her shares could become worth far more than $20,000; if it fails, she is paid only after the bank.
| Debt | Equity | |
|---|---|---|
| What the supplier gets | A contract: interest and repayment on fixed dates | Ownership: a share of whatever is left, and votes |
| Is payment promised? | Yes; missing a payment is a default | No; dividends are at the directors’ discretion |
| Order of payment if the business fails | Before shareholders | Last |
| Upside for the supplier | Capped at the promised payments | Unlimited |
| Does it have to be repaid? | Yes, by a set date | No; owners get money back by selling their shares or through dividends |
| Lantern on 1 March 2026 | $10,000 from Coastline Bank at 6%, due 1 March 2028 | $20,000 from Ana for common stock |
Who supplies capital, and what it costs
Behind every business’s capital are savers: households who have more money than they want to spend now. Sometimes they supply it directly, as Ana does, or by buying a company’s shares or bonds. More often it passes through a bank, a pension fund or an investment fund that pools many people’s savings. Module 3 follows those paths in detail. For now, the key point is that capital always belongs to someone who could have done something else with it, so it is never free.
The cost of capital to a business is the return its suppliers expect, because that is what the business must deliver to keep them willing to provide it. For debt the cost is easy to see: Lantern’s debt costs 6% a year, written into the contract. For equity no rate is written down, but there is still a cost. Ana could have left her $20,000 in the bank or invested it elsewhere, so Lantern must, over time, be expected to earn her at least as much as she could get elsewhere for a similar risk. If it cannot, she would be better off closing it and investing the money elsewhere.
If debt is cheaper, why not borrow everything? Because the promised payments are due in bad years as well as good, and missing them can end the business. The mix of debt and equity a firm chooses is its capital structure, and choosing it well is one of the central questions of corporate finance, studied in F05 Corporate Finance. This lesson only needs the trade-off: debt is cheaper but adds risk; equity is more expensive but gives the business room to survive a bad year.
Liquidity: two meanings of one word
Finance uses “liquidity” in two ways, and it matters which one is meant.
- The liquidity of an asset is how quickly it can be turned into cash, and how little value is lost in doing so. Cash is perfectly liquid. Money in a bank savings account is nearly as liquid: it can usually be withdrawn the same day at its full value. A share listed on a stock exchange can be sold in seconds, but at whatever price buyers will pay that day. An office building may take months to sell and costs agents’ and lawyers’ fees.
- The liquidity of a firm (or a person) is its ability to meet its obligations as they fall due, out of cash it has or can raise quickly. A firm is liquid if, when the rent, the wages and the supplier invoices arrive, the money is there to pay them.
The two meanings are linked. A firm or a person is liquid when enough of what they own sits towards the left of the figure compared with what they must pay soon. After 1 March Ana’s own position shows this clearly. She will own $20,000 of Lantern’s shares and $6,000 in her savings account. The shares are a stake in a small private company: no exchange lists them, and finding a buyer quickly, at a fair price, would be hard. Only the $6,000 is liquid.
Ana’s emergency fund: personal liquidity
An emergency fund is money a person keeps in liquid form to pay for the unexpected, such as a car repair, a medical bill or a month without income, without having to borrow or sell something at a bad price. It is usually measured in months of essential spending. Suppose, as an assumption for this lesson, that Ana’s essential personal costs (rent, food, insurance, transport) come to $2,000 a month. Then her fund covers months.
For Ana that cushion matters more than it did before. As an employee she earned $52,000 a year, about $4,333 a month before tax. From March her income depends on what Lantern can afford to pay her, and a new business may pay its owner little or nothing for months. Her emergency fund is what stands between a slow first season and borrowing on a credit card. Liquidity has a price, though: the most accessible places for money tend to pay the least, and her savings account pays 1.5% a year. The F00 project returns to this trade-off when Ana chooses where to keep the $6,000.
A firm’s liquidity in two numbers
To judge a firm’s liquidity, analysts compare what will turn into cash soon with what must be paid soon. Current assets are cash and the assets a business expects to turn into cash or use up within a year (or within its normal operating cycle, if that is longer): money owed by customers (receivables), inventory, payments made in advance. Current liabilities are what it must pay within a year: amounts owed to suppliers, wages, taxes, and any part of its loans due within the year.
Working capital is the difference, current assets minus current liabilities, in dollars. The current ratio is the same comparison as a ratio, current assets divided by current liabilities. Harbourline Roasters Inc., a fictional listed coffee roaster used throughout this module, reports current assets of $180 million and current liabilities of $120 million. Its working capital is million dollars, and its current ratio is : for every dollar it must pay within the year, it holds $1.50 of assets that should turn into cash within the year.
In depth
Debt and equity: claims, priority and control
The difference between debt and equity is a difference of claims: who is entitled to what, and in what order. Lenders have a claim set by the contract, and it comes first. Shareholders have a residual claim that comes last. If a business is wound up, the law ranks the claims on what its assets fetch. Lenders who hold security (a legal right over particular assets, such as a mortgage over a building) are paid from those assets first; other creditors, including unsecured lenders and suppliers, come next; shareholders receive whatever is left, which is often nothing. Investor.gov makes the same point from the investor’s side: in a bankruptcy, bondholders are paid before stockholders.
Control runs the other way. Shareholders elect the board of directors and vote on major changes; lenders have no vote. Lenders protect themselves instead through the loan contract, which can require the borrower to keep certain ratios above agreed levels or to ask permission before borrowing more. Those conditions are called covenants, and lesson 9 of this course returns to them. Some securities sit between the two forms: preferred stock carries a fixed dividend that must be paid before ordinary shareholders receive any, though the directors may skip it, and usually carries no vote, and a convertible bond is debt that the holder may exchange for shares.
Why debt is a double-edged tool: leverage
Using debt to finance part of a business is called leverage (in British usage, gearing). Because the interest is set by the loan contract, and does not rise when the business does well or fall when it does badly, everything the business earns above the interest goes to the shareholders, and every shortfall comes out of their share. Debt therefore magnifies the shareholders’ results in both directions. The table works through Lantern’s first year with three possible results, ignoring tax to keep the arithmetic clear. Operating profit here means profit before paying interest.
| Good year | Modest year | Poor year | |
|---|---|---|---|
| Operating profit (before interest) | $3,000 | $900 | $0 |
| Return on all $30,000 of capital | 10% | 3% | 0% |
| Interest to Coastline Bank | $600 | $600 | $600 |
| Left for Ana (operating profit − interest) | $2,400 | $300 | −$600 |
| Return on Ana’s $20,000 of equity | 12% | 1.5% | −3% |
If Ana had put in all $30,000 herself and borrowed nothing, her return would equal the return on all capital: 10%, 3% and 0%.
In the good year the business earns 10% on its capital but pays the bank only 6%, so the difference flows to Ana and her return rises to 12%. In the modest year the business earns 3%, less than the 6% it pays the bank, and her return falls to 1.5%. In the poor year the business breaks even before interest, yet the $600 of interest is still due, so Ana loses 3%. The more of its capital a business borrows, the stronger this effect, and the more likely a run of poor years ends in default.
A common measure of how much a firm relies on debt is the debt-to-equity ratio. Lantern’s is . Definitions vary: some analysts divide only interest-bearing debt by equity, as here, while others, including OpenStax’s Principles of Finance, divide total liabilities by equity. Always check which definition a report uses before comparing two firms.
Harbourline’s balance sheet
Harbourline’s figures in $ millions appear below. All of them, including the breakdown of its current assets and the rest of its balance sheet, come from the course case, and the next lesson uses the same figures. All of the debt is long-term borrowing: none is due within the year, so none of it is in current liabilities.
| Current assets | |
|---|---|
| Cash | $45 |
| Receivables (owed by customers) | 55 |
| Inventory (green and roasted coffee, packaging) | 70 |
| Other current assets | 10 |
| Total current assets | $180 |
| Noncurrent assets | |
| Roasting plants, equipment and other long-term assets | $480 |
| Total noncurrent assets | $480 |
| Total assets | $660 |
| Current liabilities | |
|---|---|
| Amounts owed to suppliers, wages and taxes due | $120 |
| Total current liabilities | $120 |
| Noncurrent liabilities | |
| Long-term debt (loans and bonds) | $210 |
| Other noncurrent liabilities | 30 |
| Total noncurrent liabilities | $240 |
| Shareholders’ equity | |
| Total shareholders’ equity (book value) | $300 |
| Total liabilities and shareholders’ equity | $660 |
Total liabilities: 120 + 240 = $360 million. Fictional figures.
Harbourline’s debt-to-equity ratio, on the debt-only definition, is ; on the total-liabilities definition it is . The equity figure here is the amount recorded in the accounts, its book value. The next lesson compares it with what the stock market says Harbourline’s shares are worth, which is a very different number.
Measuring a firm’s liquidity: three tools and their limits
Working capital and the current ratio treat every current asset as if it were equally close to cash. They are not. Inventory has to be sold, and often sold on credit, before it becomes cash; payments made in advance, such as a year’s insurance, will never come back as cash at all. The quick ratio (also called the acid-test ratio) leaves those out and counts only cash, short-term investments and receivables. Harbourline’s quick ratio is : without selling any inventory it could cover about 83% of what it must pay within the year.
None of these numbers has a single “right” value. OpenStax’s Principles of Finance notes that a current ratio below 1 calls for a close look at what the current assets consist of and when the current liabilities fall due, and that a ratio of 2 is quite high for many companies. A supermarket that sells its inventory within days and collects cash at the till can run safely with a current ratio below 1; a builder whose customers pay months after the work starts may need far more. Compare a firm with others in its industry and with its own past, and read the ratios together, not one at a time.
The ratios also have three blind spots worth knowing from the start. They are a snapshot: they describe one date, and a firm can arrange its affairs to look better on that date, for example by paying suppliers just before the year ends (worked example 2 shows how that moves the ratio). They ignore timing within the year: $120 million due within twelve months is very different if $100 million of it is due next week. And they ignore sources of cash outside the balance sheet, such as an unused agreement with a bank to lend on demand (a credit line), which can make a firm with modest ratios quite safe.
Liquidity is not solvency
Solvency is about the long run: whether a firm’s assets are worth more than everything it owes, so that it can meet all its obligations over time and stay in business. Liquidity is about the short run: whether it can pay what is due now. The two can come apart, and the table shows how.
| Liquid | Illiquid | |
|---|---|---|
| Solvent | Healthy: cash to pay this month’s bills and assets well above debts. Harbourline today. | A hotel owns a valuable building outright but has little cash and a large tax bill due next week. It can survive by borrowing against the building, if a lender acts fast enough. |
| Insolvent | An online retailer has plenty of cash from customers’ advance payments, but owes more than all its assets are worth. It can pay this month; it cannot pay everything it owes. | Neither: little cash and debts larger than its assets. Failure is likely. |
The illiquid-but-solvent case is the one that surprises people. A business can fail without being unprofitable or worthless: it can run out of cash before the value it has built turns into money, for example because customers pay slowly while wages are due every month. That is why lenders and suppliers watch liquidity closely, and why a growing business that buys stock and pays staff before its customers pay can be at more risk than a quiet one.
Formulas
Working capital
- Cash and assets expected to become cash or be used up within a year: receivables, inventory, prepayments$
- Obligations due within a year: amounts owed to suppliers, wages and taxes due, loan repayments due within the year$
Assumes. Both are measured at the same date, from the same balance sheet.
Positive working capital means the current assets more than cover the current liabilities. Accountants sometimes say net working capital for the same quantity.
Current ratio
- As above$
- As above; must be greater than zero$
Assumes. Treats every current asset as equally able to pay the bills.
A pure number, often written 1.5 or 1.5 : 1. What counts as comfortable depends on the industry and on how quickly the assets turn into cash.
Quick (acid-test) ratio
- Cash and bank balances$
- Investments that can be sold quickly at close to their value$
- Amounts customers owe for goods or services already delivered$
- Obligations due within a year$
Assumes. Inventory and prepayments are left out because they are slower, or never, turned into cash.
Always at most the current ratio, because its numerator is part of current assets.
Debt-to-equity ratio
- Interest-bearing borrowing (loans and bonds); some analysts use total liabilities instead$
- Shareholders’ equity as recorded in the balance sheet (book value)$
Assumes. Uses book values unless stated otherwise.
A measure of leverage. State which definition of debt you use.
Emergency-fund cover (months)
- Money that can be reached quickly at full value, such as cash and bank deposits$
- Costs that cannot easily be cut: housing, food, insurance, transport, loan payments$ per month
Assumes. Essential spending stays the same and no income arrives while the fund is used.
A personal version of the same question the current ratio asks of a firm: how long can you pay what is due?
Worked examples
Fictional figures
Harbourline Roasters Inc. has current assets of $180 million (cash $45 million, receivables $55 million, inventory $70 million and other current assets $10 million) and current liabilities of $120 million. Calculate its working capital, current ratio and quick ratio, and say what each shows.
- Working capital is current assets minus current liabilities: , so $60 million.
- The current ratio divides the same two totals: .
- The quick ratio counts only cash, short-term investments and receivables (Harbourline has no short-term investments): .
- Interpret: the current assets cover the year’s obligations 1.5 times, with $60 million to spare, but without selling inventory Harbourline could cover only about 83% of them.
Answer. Working capital $60 million; current ratio 1.5; quick ratio about 0.83.
What it means. Harbourline’s liquidity depends on selling its coffee. For a roaster that is normal: inventory is its business, and roasted coffee sells steadily. A lender would want to know how quickly that inventory turns over and whether Harbourline has an unused credit line before calling it comfortable or tight.
Fictional figures
Two days before its year end, Harbourline’s finance director considers two moves. (a) Use $30 million of cash to pay suppliers early. (b) Instead, borrow $20 million on a five-year loan, repayable in one sum, and keep the cash. Starting from the figures in example 1 (and book equity of $300 million, debt of $210 million), calculate working capital, the current ratio and the quick ratio after each move, and the debt-to-equity ratio after (b). Has either move made Harbourline more liquid?
- (a) Paying suppliers reduces cash (a current asset) and amounts owed (a current liability) by $30 million each. Current assets , current liabilities . Working capital : unchanged, because both sides fell by the same amount.
- (a) Current ratio , up from 1.5. Quick ratio , down from 0.83: quick assets fell by 30% (100 to 70) while current liabilities fell by 25% (120 to 90).
- (b) Borrowing long-term adds $20 million to cash; the loan is not due within the year, so current liabilities stay at $120 million. Current assets ; working capital ; current ratio ; quick ratio .
- (b) Debt-to-equity rises from 0.7 to , and Harbourline will owe more interest every year.
- Judgement: (a) lifts the current ratio while leaving less cash for next week’s bills, so it flatters the headline number without making the firm more liquid. (b) genuinely adds cash available now, at the price of more debt and interest later: more liquid, slightly more leveraged.
Answer. (a) Working capital $60 million, current ratio about 1.67, quick ratio about 0.78. (b) Working capital $80 million, current ratio about 1.67, quick ratio 1.0, debt-to-equity about 0.77.
What it means. Two moves produce the same current ratio and very different businesses. A ratio measured on one date can be nudged; an analyst who sees a sudden improvement should ask how it was achieved, and look at the quick ratio, the cash and the debt as well.
Fictional figures
Voltwell Storage, a fictional installer of home battery systems, asks its bank for a $300,000 credit line to cover a busy season. Its current assets are cash $120,000, receivables $380,000 and inventory of battery modules $900,000. Its current liabilities are $1,000,000, of which $700,000 is owed to its battery supplier within 60 days. Its total assets are $3,200,000 and total liabilities $2,100,000. Assess its liquidity and its solvency.
- Current assets . Working capital ; current ratio .
- Quick ratio . Cash and receivables cover only half the year’s obligations, and less than the due to the supplier within 60 days.
- Solvency: equity (assets minus liabilities) is , so on its books Voltwell owns more than it owes.
- Judgement: Voltwell looks solvent but tight on liquidity. Paying its supplier on time depends on installing and billing the batteries it holds within weeks. A credit line fits exactly this gap: cash while inventory turns into receivables and receivables into cash.
Answer. Current ratio 1.4 and working capital $400,000, but a quick ratio of only 0.5; solvent, with book equity of $1,100,000.
What it means. A banker would probably lend, but with care: for example, by limiting the line to a share of Voltwell’s receivables, so that the bank’s exposure grows only as the inventory is actually sold. The decision rests on the quick ratio and on timing, not on the reassuring current ratio alone.
Explore
Common mistakes
“Equity is free money, because the business never has to pay it back.”
Shareholders are not promised anything, but they expect a return, and a higher one than lenders, because they bear more risk. A business that does not earn its shareholders an adequate return over time will find it hard to raise more equity, and its owners would do better to invest elsewhere. Equity has a cost even though no rate is written in a contract.
“A profitable business can’t run out of cash.”
Profit and cash arrive at different times. A business that sells on 60-day credit while paying wages every fortnight can be profitable on paper and unable to pay this month’s bills. That is a liquidity problem, and it sinks businesses that would otherwise have survived.
“Liquid and solvent mean the same thing.”
Liquidity is the short run: can you pay what is due now? Solvency is the long run: are your assets worth more than everything you owe? A hotel that owns a valuable building but has no cash is solvent and illiquid; a retailer with plenty of customer cash but debts larger than its assets is liquid and insolvent.
“A higher current ratio is always better.”
A very high current ratio can mean idle cash, slow-moving inventory or customers who are not paying, all of which tie up money that could earn more elsewhere. What is comfortable depends on the industry and on how quickly the current assets turn into cash. Compare with peers and with the firm’s own history, and look at the quick ratio too.
“Working capital is money the investors put in.”
Working capital is a difference between two groups of balance sheet items, current assets and current liabilities. It is not a source of capital at all. The investors’ money is the debt and equity on the other side of the balance sheet.
“Ana has $26,000 of savings, so she is well covered.”
After 1 March only $6,000 of it is liquid. The $20,000 has become shares in a small private company, which she cannot sell quickly at a fair price. Personal liquidity counts only what can be reached quickly at full value.
Guided practice
Work through these with hints when you need them. Every hint and every worked solution is there to be used.
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On your own
No hints this time. Answer, check, and read the feedback; the solution appears once you have answered or if you ask for it. Your first answers count toward mastery.
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In practice
Two professionals use this lesson’s vocabulary every week: the treasurer who manages a firm’s cash and a credit analyst at a lender or supplier.
Fictional case
Pinecrest Lodge, a fictional 80-room ski hotel, earns most of its revenue between December and March. Its treasurer, Mara Okafor, is planning the year in September, when the hotel is quiet and its cash is at its lowest.
Mara’s problem is liquidity, not solvency. The hotel owns its building and earns a healthy profit over the year, but in October and November it must pay for staff training, linen, food stock and the property tax, while very little money comes in. She draws up a month-by-month forecast of cash in and out, finds the lowest point (early December, just before the first guests pay), and compares the shortfall with the hotel’s cash. Then she arranges a credit line with the hotel’s bank in advance, sized to cover that low point with a margin, because a lender asked for money in a hurry, by a borrower who is already short, offers worse terms or none at all.
She also thinks about the capital behind the hotel. Pinecrest already has a mortgage on its building; borrowing more for a new spa would raise its debt-to-equity ratio and the interest due every month of the year, including the quiet ones. When the owners consider the spa, Mara’s advice is to fund at least part of it with equity, so that a poor snow season cannot leave the hotel unable to meet its debts. That is the leverage trade-off from this lesson, applied to a real choice.
On the other side of the table, a credit analyst at the hotel’s linen supplier reads the same numbers to decide how much to sell to Pinecrest on 30-day credit. She calculates the current and quick ratios from the hotel’s latest balance sheet, notes the date it was drawn up (a balance sheet at 31 March, at the end of the season, looks far more liquid than one at 30 November), and asks whether the hotel has a credit line in place. A supplier is a short-term lender, so liquidity is the first thing it checks.
The same questions scale down to one person. Before she resigns, Ana writes a short plan of her own: $6,000 kept liquid as an emergency fund (three months of essential spending on her estimate), Lantern’s first $150 interest payment due to Coastline Bank on 1 June, and no personal borrowing planned. Coastline Bank’s loan officer asked about the same things when lending to Lantern: who supplies the capital, how much of it is debt, and how the business will pay its bills before its customers do.
Knowledge check
Six questions, one attempt each, no hints. Score 80% or more to complete the lesson; you can take it again at any time.
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Summary
- Financial capital is money supplied to a business by investors; it comes as debt (a contract with promised interest and repayment) or equity (ownership with a residual claim and no promised payments).
- Lenders are paid first and their upside is capped; shareholders are paid last and their upside is unlimited. Because shareholders bear more risk, equity is expected to cost a business more than debt.
- Debt is leverage: it magnifies shareholders’ returns in good years and their losses in bad ones, and its payments are due whatever happens.
- An asset is liquid if it can be turned into cash quickly with little loss of value; a firm or person is liquid if they can pay their obligations as they fall due.
- Working capital is current assets minus current liabilities; the current ratio divides them; the quick ratio leaves out inventory and prepayments. Harbourline: $60 million, 1.5 and about 0.83.
- Liquidity (paying what is due now) and solvency (assets worth more than everything owed) are different; a firm can have one without the other.
- Ana’s $6,000 emergency fund is her personal liquidity: about three months of essential spending on this lesson’s assumption, while her $20,000 in Lantern is illiquid.
Key formulas
- Working capital
- Current ratio
- Quick (acid-test) ratio
- Debt-to-equity ratio
- Emergency-fund cover (months)
Terms introduced
- Capital
- In finance, the money supplied to a business by investors, as debt or equity, to buy the assets it needs. The assets themselves (machines, buildings) are sometimes called physical capital.
- Debt
- Money borrowed under a contract that promises the lender interest and repayment of the principal on stated dates. Lenders do not own the business and are paid before shareholders.
- Equity
- The owners’ residual claim on a business. In the accounts it is assets minus liabilities (book value); in finance it is money invested in exchange for ownership, paid after lenders and other creditors, with no promised payments and no limit on the upside.
- Interest
- The price of using someone else’s money: what a borrower pays a lender, usually stated as a percentage of the amount borrowed per year.
- Principal
- The amount originally borrowed or invested, on which interest is calculated.
- Default
- Failure to make a promised interest or principal payment on time, which gives the lender the right to take legal action to recover what it is owed.
- Cost of capital
- The return that the suppliers of a business’s capital expect, and so the return the business must be expected to earn to keep their money. For debt it is close to the interest rate; for equity it is the return shareholders could expect elsewhere for a similar risk.
- Capital structure
- The mix of debt and equity a business uses to finance its assets.
- Leverage
- The use of debt to finance part of a business. Because interest is set by the loan contract and does not rise when the business does well, leverage magnifies shareholders’ gains and losses. Also called gearing.
- Debt-to-equity ratio
- Debt divided by shareholders’ equity, a measure of leverage. Some analysts use interest-bearing debt in the numerator, others total liabilities.
- Liquidity
- For an asset, how quickly it can be turned into cash with little loss of value. For a firm or person, the ability to meet obligations as they fall due.
- Solvency
- The ability to meet all obligations over the long run, because assets are worth more than everything owed.
- Emergency fund
- Money a person keeps in liquid form to cover unexpected costs or a loss of income, usually measured in months of essential spending.
- Current asset
- Cash, or an asset expected to be turned into cash, sold or used up within one year or the operating cycle, whichever is longer, such as receivables, inventory and prepayments.
- Current liability
- An obligation expected to be settled within one year or the operating cycle, whichever is longer, usually out of current assets, such as amounts owed to suppliers, wages, taxes and loan repayments due within the year.
- Working capital
- Current assets minus current liabilities: the short-term cushion in a firm’s balance sheet. It is a measure, not a source of capital.
- Current ratio
- Current assets divided by current liabilities: how many dollars of current assets a firm holds for each dollar it must pay within the year.
- Quick ratio
- Cash, short-term investments and receivables divided by current liabilities. It leaves out inventory and prepayments. Also called the acid-test ratio.
Sources
- Dahlquist, J. & Knight, R. (2022). Principles of Finance, section 6.3, “Liquidity Ratios”. OpenStax. openstax.org/books/principles-finance/pages/6-3-liquidity-ra…
- Dahlquist, J. & Knight, R. (2022). Principles of Finance, section 6.4, “Solvency Ratios”. OpenStax. openstax.org/books/principles-finance/pages/6-4-solvency-rat…
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