The capital and drawings are both well known and generously used terms within the business world. However, they are often misunderstood by those with less familiarity to business terms and concepts. Every business, be it a startup or a running business, needs a strong and stable capital structure to survive and thrive. On the other hand, drawings from a business act as a contra-capital movement where funds from a business are fetched out by the investors.

The article below looks into the concept of capital and drawings and the key differences between them.

Definitions and meanings

Capital

In context of business and finance, the term capital refers to the total amount of money invested in a commercial entity by its owners and promoters for the purposes of establishing and running a business. However, practically speaking, capital is a broader term that may includes anything invested into a business. Owners can bring capital to their business in the form of cash or non-cash assets in any shape such as plant and machinery, intellectual properties, tangible properties like land and building etc.

Once brought to the business, the amount of capital is invested in different assets and processes for running day-to-day operations.

Contribution of capital by owners in various business formats:

As stated earlier, capital is an essential item to start a business. If an individual wants to set up a sole proprietorship, he will be solely responsible to manage the whole amount of capital to finance his business. If two or more persons choose to establish a partnership firm, they will all be collectively responsible to contribute towards their firm’s capital. However, with mutual consultation among all the partners, a person can be accepted as partner into the firm without capital just on the basis of his skills, knowledge, capabilities and wisdom.

In case of a company, the capital is divided into smaller denominations of fixed amounts known as shares. These shares are sold and issued to individuals and organizations to raise initial capital and start operations. The individuals and organizations to whom share certificates are sold become the shareholders or stockholders and enjoy the ownership status in the company. Such arrangement of raising capital by companies is typically termed as equity financing. To obtain equity financing in future, the company may further sell its shares against the injection of capital into the business. The equity capital of a company can be broadly divided into four main types.

  1. Authorized or nominal capital
  2. Issued capital
  3. Subscribed capital
  4. Paid-up capital

Example

ENT Ltd. is a public company with an authorized capital of $2 Billion (divided into shares of USD 10 each). The company initially issued 100,000 shares for $10 each. In 2016, ENT Ltd. set up a Greenfield project, and to finance it, the company decided to issue 500,000 shares for $20 each. The capital structure of the company as of the end of the year 2016 is as follows.

  Number of Shares Capital ($)
Authorized Capital 200,000,000 shares $2,000,000,000
Share Capital (at par value of USD 10 each) 600,000 shares $6,000,000
Share Premium $5,000,000

After the success of the previously set up project, the company is now desirous of setting up another project and requires equity funding worth $60 million for it. It has therefore made an offer for issuance of 200,000 shares at a premium of $30 each. The capital structure of the company will, therefore, change as follows.

  Number of Outstanding Shares Outstanding Capital ($)
Authorized Capital 200,000,000 shares $2,000,000,000
Share Capital (at par value of USD 10 each) 800,000 shares $8,000,000
Share Premium $9,000,000

Drawings

Contrary to the concept of capital, drawings represent the money withdrawn from a business. Simply put, an owner may withdraw some cash or assets from his business for his personal use, whenever needs. These are not to be confused with expenses, salaries, or wages which are the day-to-day costs incurred for running a business. Drawings are, in fact, shown as a reduction in assets and capital.

If made in the form of cash, it is easy to ascertain the value of money withdrawn from a business. However, if an owner withdraws goods or assets from a business for his personal use, it may involve expertise to determine the value of drawings to be booked.

Within a public company, drawings are made in the shape of dividends that the company’s management periodically announces and distributes among stockholders.

Example

George owns and runs a business manufacturing and selling bicycles under the business name of George Bicycle Inc. He, being the sole proprietor, often invests additional funds into the business when needed. The present capital of George Bicycle Inc. stands at $2000,000.

However, recently, George was met with an urgent need for money, and being short on cash, he decided to withdraw $5,000 from the bank account of his business – George Bicycle Inc. In addition to the cash drawings, he also took home a bicycle from the warehouse for his son’s birthday. The bicycle withdrawn by George is sold for $100, whereas it costs $70 to George Bicycle Inc. After these withdrawals, the owner’s capital in the business will be impacted as follows:

Amount in dollars
Business Capital $2,000,000
Less: Cash Drawings $(1000)
Less: Inventory Drawings $(70)
$1,998,930

Difference between capital and drawings

The seven key points of difference between capital and drawings are stated as follows:

1. Meaning

  • Capital refers to the money or assets invested into a business by its owners.
  • On contrary, drawings refer to the money withdrawn from a business by its owners for their personal use. Drawings can be made in the form of cash or assets or goods produced by an entity.

2. Journal entry to book transaction

  • When capital is brought into the business, cash or a non-cash asset account is debited and capital account is credited.
  • When cash or some other asset like merchandise are withdrawn from the business, drawings account is debited and cash or a non-cash asset account is credited.

3. Impact on financial statement items

  • Injection or introduction of fresh capital into business in any form is an inflow of resources which causes an increase in the value of both capital as well as assets of the business entity.
  • Drawings, on the other hand, is an outflow of resources which causes a reduction in the value of both capital and assets of the entity.

4. Nature of account

  • A capital account is an equity account by nature and, therefore, normally has a credit balance. It means it gets a credit each time the owner brings new capital in the business.
  • A drawings account is a contra equity account by nature which means it gets a debit each time the owner makes drawings from the business.

5. Usage

  • Businesses use the capital for meeting their operational and financing needs. It is used to pay the day to day running costs of the business, production of goods and services, and for all other purposes intended to generate profit for the business.
  • Drawings are made by the owner to meet his own personal needs.

6. Impact of operating results on reported amount

  • The amount of capital to be reported in year end balance sheet is essentially impacted by the operating results of the entity. The balance in a capital account increases by the profit generated and decreases by the loss sustained by the entity during the period.
  • The drawings has no such connection with the operating results of the entity. A drawings account is maintained to account for owner’s withdrawals and its balance causes a reduction in the amount of capital, when reported in the balance sheet.

7. Impact on working capital position

  • Capital brings current asset into the business (mostly in the form of cash) and, hence, has a positive impact on the working capital position of business.
  • Drawings, on the other hand, cause an outflow of current assets (mostly in the form of cash) and, hence, exert a negative impact on working capital available with the business.

Conclusion:

Capital and drawings both result in the flow of assets between business and its owners i.e., these are the transactions between business and its owners. The capital of a business is one of the most vital constituents for establishing, developing, and running a business. Capital for a start-up or an existing business is the fuel that it needs to sustain as a going concern.

The concept of drawings however plays an opposite role as it refers to freeing money from a business for the personal use of owners. The concept of capital and drawings move in directions opposite to each other but are equally important for understanding the basics of business financing.