Calculating a Firm’s Net Capital
Before examining the SEC’s net capital requirements for the various types of broker-dealers, let’s spend some time understanding the term itself. Net capital refers to the liquid value of a firm. A firm’s liquid value is the amount of liquid assets remaining after its liabilities have been paid off. The following equation is used by the SEC to determine a firm’s net capital:
net capital = net worth + subordinated debt – non-allowable assets – haircuts
Clear as mud? Let’s break it down.
Net worth. Net worth is the difference between assets and liabilities. On a balance sheet, the difference between assets and liabilities is called owners’ equity. Net worth is equal to owner’s equity. Assets are what a firm owns. Liabilities are what a firm owes to outsiders. Owners’ equity is what a firm owes to its owners. When a firm first opens for business, owners’ equity is the amount of cash owners put into the business or the amount of securities a firm sells to the public. For a business already in operation, owners’ equity is what is left over from a firm’s assets after all liabilities have been paid. In other words, it is a residual. Owners’ equity can be more or less than the owners’ original investment.
net worth = owners’ equity = assets – liabilities
An equivalent equation is the following:
assets = liabilities + owners’ equity
Liquid assets. Assets are a firm’s resources. They include cash, securities, property, inventory, and office equipment. Liquid assets are assets that can quickly be converted into cash. The securities a firm owns are a liquid asset. So are the securities a brokerage holds on behalf of a customer, just as the cash acquired from a bank loan is a liquid asset.
Subordinated debt. Subordinated debt is comprised of debt that ranks below other debt in its claims on assets or earnings during a bankruptcy or liquidation. For example