2.8.1. Net Capital
To protect customers and creditors from the risk of a firm becoming insolvent, the SEC requires each broker-dealer to calculate and report its net capital daily. A broker-dealer must maintain a minimum net capital at all times. This minimum depends on the type of broker-dealer and how much debt it has. A firm must suspend all business operations if it falls under its minimum net capital.
Net capital is an estimate of how much the firm could raise if it needed to quickly liquidate its assets. In other words, net capital tells you approximately how much cash the firm would have to pay back customers if the firm fails.
In order to make this estimate as accurate as possible, the net capital calculation is quite complicated. Generally speaking, an asset’s contribution to net capital will be based on (1) its market value and (2) whether the firm can sell it at market value quickly. 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? We will define each of these concepts in turn. Let’s break it down.
Net worth. This is probably most familiar term in the net capital equation. Net worth is the difference between the firm’s assets and its liabilities. This is the starting point for calculating net capital; the other terms in the equation are adjustments to the various assets and liabilities that constitute net wort