Capital formation has a major role to play in the development of any economy. In any economy, there is a constant inflow of money from various sources. The quantum of capital formation in the economy during a certain period is equal to amount of investment that takes place in that economy during that period. In order to make investment, the company has to forgo distribution of some of its profits, which could have been otherwise distributed to its shareholders.

It decides to deploy a part of its surpluses in purchasing assets like machinery, for construction, roads or other infrastructural facilities. The purpose of any investment is to increase the profits of the future periods. If the investments made now are successful, then the company will have a higher surplus in future, the company can invest that surplus to attain fixed assets that have long term value, in such a case it is known as fixed capital formation. When company invest in stocks of raw materials, or any other short term investments it is known as short term capital formation. From an economic point of view fixed capital formation is more important than alteration in inventories.

Since capital formation involves huge resources and more time lag is there in it therefore it is government through public sector enterprises which plays a significant role in capital formation.

Capital formation is difficult to measure statistically, mainly because of the valuation problems involved in establishing the value of capital assets. Capital assets can for example be valued at historic (acquisition) cost, current replacement cost, current sale value, average market value, or scrap value. Hence different value comes when it is valued according to a particular method and therefore there are always contradictory views about it.

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