Economic Capital

Simply put, economic capital is the funding required by a company in order to continue to operate, pay its debts, and avoid insolvency. While there is no legal requirement for most companies to maintain sufficient economic capital, companies that fail to do so typically receive lower credit rating and, in extreme cases, may be denied further corporate credit altogether. Failure to maintain an appropriate level of economic capital can also lead to decreased investment in the company, further reducing the amount of funding available for use.

Economic capital definition

The classic definition of economic capital is the amount of money required by a company in order to continue profitable operation and pay its debts on a continuing basis. Economic capital consists of liquid assets, rather than capital assets; capital assets cannot be quickly liquidated in order to provide operating funds, and thus are not useful sources of economic capital. Liquid assets typically include ready cash at hand as well as corporate banking accounts, bonds, and mutual fund accounts. These assets can easily be converted into cash to support the ongoing operations of the company.

Economic capital implications

Credit rating agencies and banking institutions regard the measure of economic capital that a company maintains as one of the most reliable indicators of the company’s financial stability. Economic capital is essentially the financial life blood of a company, and failure to maintain an adequate reserve can spell economic disaster and the eventual collapse of the company. The amount of economic capital required varies from company to company depending on the risk factors assumed; lower risk enterprises require less economic capital since they are less likely to experience catastrophic losses. For instance, a company that accrues a large amount of debt and depends heavily on volatile stocks for its ongoing operating funds will require a greater reserve of economic capital than one that has few outstanding debts and minimal risk to its investments.

Economic capital model

Financial institutions and investment analysts use a variety of economic capital models to determine the creditworthiness and overall stability of corporate entities. Typically, an economic capital model measures the outstanding risk assumed by a company against its ongoing income and liquid assets. Ideally, a company will maintain economic capital equal to or exceeding its risk factors. The economic capital model used by some corporate credit agencies also incorporates available credit as a factor in determining the available cash on hand. This allows companies with excellent credit ratings and a large supply of available credit to maintain a smaller reserve of economic capital while continuing to present an attractive prospect to potential investors.

<< Risk Management
<< Types of Risk
Value at Risk (VAR) >>
Shareholder Value Added >>
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
Day Trading Simulator provides the ability to simulate day trading 24 hours a day from anywhere in the world. TradingSim provides tick by tick data for...

Send this article to a friend.

Enter multiple addresses on separate lines or separate them with commas.