What is Capital Maintenance?
Capital maintenance is an accounting principle that states a company’s profits can be calculated only after the amount of the starting capital is fully regained. In some cases, only a partial amount of the capital is to be maintained. A company has greater chances of overcoming business risks and financial threats if its capital is regained or maintained.
This accounting approach can also be a method for computing a person’s net income. For instance, a person already has $10,000 US Dollars (USD), and earns $30,000 USD more. His existing funds are then subtracted from his earnings, which makes his net income total $20,000 USD. This is a contrasting accounting concept to the transaction method, in which a person’s expenditures are subtracted from his income.
Capital maintenance involves two sub-concepts: the financial and the physical capital. In the financial type, only the money is included in computing a company’s net asset. The financial funds initially owned by the company are deducted from the earnings in a specific duration. If the computed amount exceeds the initial amount, then the company has earned a profit.
In physical capital maintenance, non-financial or physical capital and assets are taken into account, such as machines, transportation, and material supplies. Even the office itself is considered physical capital. The company’s initial working capacity is compared to the working capacity at the end of a period. If the physical assets increase the company’s capacity to operate, the company has produced revenues.
The physical approach provides a more holistic way of calculating profits, as it includes non-financial aspects, such as machinery, time, and labor. The financial approach, on the other hand, offers a more practical and tangible method by computing finances with a fixed value. Capital maintenance also includes a term called “capital recovery,” which occurs once a company earns back the amount of its starting capital. Once the capital is regained, the succeeding earnings are already considered profits.
Capital maintenance is important for companies not only to prevent future setbacks, but also to estimate their total value. The accounting concept is also essential to creditors to help them decide whether a company qualifies for a loan. Many companies today get their starting capital from bank loans, and capital maintenance provides a point of reference for how long it will take a loan to be paid back.
@NathanG - In my opinion, these distinctions are made for investment purposes. Investors or banks want to look at a balance sheet and see if you’re worth investing in.
To that end, I prefer the holistic capital maintenance approach which takes into account physical and financial capital. A company that pays back both physical and financial capital is very attractive indeed. Every dollar in earnings then is pure gravy.
There are not many businesses that operate on this margin, from what I can tell. Most businesses just want to show that at least they're servicing debt on their existing capital requirements.
But when profits are squeezed thin and the economy is tight, being able to show that you are, for all practical purposes, in the black on your capital repayment, makes you an attractive company for investors and even for other potential suitors in the case of a buyout.
@hamje32 - I think you’re describing physical capital, which as the article says is one of the sub-concepts of the capital maintenance definition.
You don’t necessarily have to include physical capital in your calculations. You can choose financial capital alone. In the case of the telecommunications network, you would look at all the bank loans and stuff like that which are used to finance the build out of the network.
Those loans represent your capital, and they must be repaid (at least in part) before you calculate a profit. I think that’s fair, and actually more ideally suited for the capital intensive businesses like telecommunications or energy companies.
I think this would be a troublesome concept for very capital intensive businesses.
Take the telecommunications industry for example. That industry is extremely capital intensive; miles of switches, routers and fiber need to be laid before the company can be up and running.
Under this capital maintenance concept, not a dollar of profit can be realized until that capital has been regained or paid for, or at least a certain percentage of it has.
That’s a tall order in my opinion, and I don’t think that it should be relevant. The company should be looking at its operating expenses to determine a baseline for knowing when and how it becomes profitable.
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