Third Party Capital is the external resources that companies seek to finance their activities, from third parties, such as loans.
In accounting, the capital of third parties is formed by all the Liabilities Payable. These amounts constitute the obligations acquired under credit agreements and are repaid to creditors after a period of time.
Some examples of liabilities that make up third party capital, in addition to loans, are financing and debt to suppliers.
Differences between Third Party Capital and Equity
The capital that the company finances through third parties is different from Equity, in which capital inflows occur through partners or shareholders.
When starting the venture, the first investment made by the partners is known as Share Capital and it is this that constitutes the initial Shareholders’ Equity. From this, as more investments appear by the partners or shareholders, there is an increase in Equity.
Third Party Capital is another way that managers seek capital to invest through external resources, without involving new partners and with debts to be paid within a certain period.
Total Capital Available to the Company
Another concept is that of the Total Capital at the Entity’s disposal, which represents all the resources in which the company financed itself.
This capital can be obtained from the balance sheet by adding the liabilities and shareholders’ equity, which results in the value of the so-called total assets.
A capital inflow of any kind ends up being invested in some asset, or remains in the company’s cash. In the case of a loan when contracted, it becomes a liability to be paid, while it is invested in the purchase of machinery (assets), for example.
Cost of third party capital
It is possible to measure the cost of holding third party capital and the return it provides to the profitability of the company’s projects.
Using the formula we obtain a percentage that indicates how much the company has taken out of third party capital for each US $ 100.00 of invested equity:
(Current Liabilities + Long-term liabilities) / Equity x 100
In the case of indebtedness, the cost of equity capital relates to the interest paid, discounted from the Income Tax rate, divided by the capital of third parties.
Kt = Interest (1 – IR) / Third Party Capital x 100
The result reveals the percentage added to the debt due to the interest paid.
Advantages and Disadvantages of Third Party Capital
In credit operations, one of the biggest impasses is having to pay the interest on the debts in question. This is mainly for smaller companies, where financial institutions charge higher interest rates.
Still, for many businesses it can be more advantageous than sharing the company’s capital with new partners or shareholders.
Advantages of Third Party Capital
- Being formed by external resources, it has a commitment only until the debts are settled;
- It is recommended for projects that have a long-term return, that is, after the extinction of the debt they still generate profits for the company;
- The debt to be paid is known since the contract, generating greater predictability for the administrator.
Disadvantages of Third Party Capital
- The larger, the more indebted the company will be;
- The debts contracted by the company bear interest;
- By choosing this path instead of inviting another partner, management fails to gain additional know-how;
- If one or more projects do not achieve the expected profitability, it may jeopardize the company’s capital, while the debt still has to be repaid.