Understanding the Difference Between Working Capital and Fixed Capital

Understanding the Difference Between Working Capital and Fixed Capital

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Jaya
Jaya Sharma
Assistant Manager - Content
Updated on Dec 18, 2023 17:10 IST

Both working capital and fixed capital are required for the smooth business operations. If the business lacks any of these two, it will directly impact the operations. In this article, we will be discussing the difference between working capital and fixed capital. Let us first get started by discussing these types of capital individually.
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Table of Contents

Difference Between Working Capital and Fixed Capital

Let us now learn the difference between working capital and fixed capital:

Parameter Fixed Capital Working Capital
Investment Investing money into the long-term assets of the organisation Investing money in the current assets of the organization
Types of assets acquired Non-current assets for the firm Current assets of the company
Liquidity Not liquid Extremely liquid
Conversion Cannot be immediately converted into cash or kind Can be immediately converted into cash or in kind
Term Serves business for an extended time period Serves business for a concise time period
Accounting period More than one accounting period Lesser than one accounting period
Objective Serves strategy-oriented goals Serves operational goals
Consumption Does not directly consume the business but indirectly serves the business Needs working capital for operations

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What is Working Capital?

Working capital refers to the amount of capital available with a company for fulfilling the short-term and day-to-day business requirements. Without the availability of working capital, the organization lacks funds for running a business. On the contrary, excessive working capital is not healthy as it increases the cost of business. For calculating the working capital that is required for running business operations, it is important to deduct passive expenses from monthly income. 

Working Capital = Current Assets + Current Liabilities

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A business may need additional working capital due to the following reasons:

  1. Extended waiting period: For day-to-day operations, wages or taxes, the business cannot completely rely on the customers to pay. For such crucial business requirements, the business must have the availability of working capital.
  2. Financial obligations: Whenever the business has financial requirements, it needs additional working capital.
  3. Business growth: For the purpose of expanding the business, working capital is required for operational purposes.

Factors Impacting Working Capital

Several factors impact the availability of working capital with the business:

  1. Turnover: The requirement for working capital depends directly on the volume of sales. As business operations increase, the requirement for working capital increases. 
  2. Inventory turnover: The frequency at which the inventory is sold or replaced, the requirement for working capital decreases. Higher turnover of inventories is accompanied by higher turnover of the accounts receivable for the working capital to remain available for use in the operations cycle.
  3. Purchase conditions: The purchase conditions of merchandise also impact the high or low requirement for working capital. With favourable credit conditions under which purchases are made, lesser cash will be invested in inventory.

What is Fixed Capital?

Fixed capital refers to the assets and capital investments that are required for starting and operating a business at a minimal stage. These are fixed assets that are either consumed or destroyed during goods and service production. However, these assets have a reusable value. Such investments undergo depreciation on the accounting statements over 20 years. 

Fixed capital is a part of the total capital outlay of a business that is invested in physical assets that permanently stay in the business for at least one accounting period. These can be purchased or owned by a business and can be structured as long-term leases. A fixed asset can be reused or resold at any point of time before its useful life is completed. It can be contrasted with variable capital. 

Types

Fixed capital includes those assets that help in generating revenue over an extended period of time. These assets are not liquid in nature and cannot be easily converted into cash. Following are the different types of fixed capital:

  1. Equipment: This is a fixed capital that is used for producing goods and services. Vehicles, machines and tools are the types of equipment that are used as fixed capital. 
  2. Building: It is an important type of fixed capital since it serves multiple purposes. Buildings can be used for the purpose of storage, office space or can also serve as manufacturing facilities. 
  3. Intellectual property: These assets are used for revenue generation in the business. This includes copyrights, trademarks, and other intangible assets that can be licensed or sold to other companies. Due to this ease, they offer a competitive advantage to the company.
  4. Infrastructure: This physical system is used for smoothly operating the business. Such physical systems include utilities, bridges, roads and telecommunication networks. 
  5. Land: It is one of the largest fixed assets that can be utilized for numerous purposes. Land can be used as office space, storage place or to start a factory. The value of land increases with time. 
  6. Natural resources: These resources include gases, oil, and minerals that are crucial for the production process. 

Factors Impacting Fixed Capital

Fixed capital refers to the long-term investments a company makes in assets such as buildings, machinery, and equipment, which are used over several years. The amount of fixed capital required by a business can be influenced by various factors:

Nature of Business

  • Capital Intensity: Industries that are capital-intensive, such as manufacturing or utilities, require more fixed capital for machinery and equipment compared to service-based industries.
  • Scale of Operations: Larger businesses typically need more fixed capital than smaller ones due to the scale of their operations.

Business Lifecycle Stage

  • Startup Phase: New businesses may require significant fixed capital to purchase the necessary assets to commence operations.
  • Growth Phase: As a company grows, it may need to invest in additional fixed capital to expand its production capacity or operational facilities.
  • Maturity: Mature businesses might require less fixed capital investment, focusing instead on the replacement and maintenance of existing assets.

Technology

  • Technological Advancements: The need for new, more efficient technology can drive investment in fixed capital as businesses strive to remain competitive.
  • Obsolescence Rate: High rates of technological obsolescence can lead to more frequent replacement or upgrading of fixed assets.

Economic Conditions

  • Interest Rates: Lower interest rates can reduce the cost of borrowing to finance fixed capital investments, while higher rates can have the opposite effect.
  • Economic Cycles: During economic downturns, companies may delay investments in fixed capital due to uncertainty and reduced demand.

Management Decisions

  • Strategic Plans: Management’s strategic vision for the company, including plans for diversification or consolidation, can impact fixed capital requirements.
  • Asset Utilization: Decisions on whether to lease or buy can affect the level of investment in fixed assets.

Government Policies

  • Tax Incentives: Tax credits for investment in certain assets or industries can encourage fixed capital investment.
  • Depreciation Methods: The allowed methods for depreciating fixed assets can affect the timing and amount of capital investment.

Market Conditions

  • Demand Forecasting: Expected future demand for a company’s products can influence the amount of fixed capital needed to meet that demand.
  • Competition: The level of competition in the market can compel businesses to invest in fixed capital to improve efficiency and reduce costs.

Access to Capital

  • Funding Availability: The ease of access to finance, through either equity or debt, can significantly impact a company’s ability to invest in fixed capital.
  • Cost of Capital: The overall cost of raising capital (including equity and debt) can influence the decision and ability to invest in fixed assets.

Regulatory Environment

  • Environmental Regulations: Stricter environmental regulations may require investment in new, compliant equipment.
  • Safety and Other Regulations: Regulations affecting industry operations may necessitate upgrades or replacements of fixed assets.

Globalization

  • Global Supply Chains: Companies may need to invest in fixed capital abroad to set up production facilities closer to key markets or resources.
  • Cross-Border Competition: The need to compete with foreign companies might drive investment in more advanced fixed capital.

FAQs

How is Fixed Capital Financed?

Fixed capital is typically financed through long-term financing sources like equity, long-term loans, or retained earnings. This is due to the long-term nature of the assets being financed.

Can fixed capital change over time?

Yes, fixed capital can change as a business expands its capacity or upgrades its facilities. Depreciation of assets also affects the value of fixed capital over time.

What is negative working capital?

Negative working capital occurs when a company's current liabilities exceed its current assets. This might indicate potential liquidity problems, but it can also be typical in some business models where quick inventory turnover or rapid collection of receivables occurs.

How is working capital different from cash flow?

Working capital is a snapshot of a company’s short-term financial health, whereas cash flow is a measure of the actual cash generated or used over a specific period. While related, they focus on different aspects of financial management.

About the Author
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Jaya Sharma
Assistant Manager - Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio