A businessman needs to invest capital in a business to operate efficiently. It’s divided further into two different parts. These are fixed capital and capital for work. Before going into the differences between fixed capital and working capital, it’s important to know that a company has to have both fixed capital and working capital at hand. In addition, the management should endeavor to maintain a balance. A perfect balance between the two will allow the company to create more money and to ensure that the firm operates smoothly.
Fixed and working capital are equally crucial to a small firm. The basic duty of the finance manager is to ensure the availability of finance, to satisfy multiple goals such as initial promotion, fixed capital, and working capital. Fixed capital refers to the money spent on acquiring fixed assets for a company. Working capital, on the other hand, is the amount of money used to fund day-to-day business activities. It is essential to support the effective running of the company’s business activities.
The two primary categories of capital are fixed capital and working capital which differ on account of their use in the firm i.e. if it is used to meet long-term requirements, it is defined as fixed capital and is known as working capital if it meets short-term requirements. Taking a look at the differences between fixed capital and working capital in this article can help comprehend them better.
Difference Between Fixed Capital and Working Capital
Difference based on the definition
The first difference between fixed capital and working capital is its definition. The capital investment made in the company’s long-term assets is referred to as fixed capital. It is a necessity that a company must begin a business or operate its existing business during its early phase. This component of the total capital is not used for production but is held for more than one accounting year in business. It is almost permanent that exists in the form of the company’s tangible and intangible assets.
The amount of fixed capital required in every firm is determined by its nature; for example, manufacturing companies, railways, telecommunications, and infrastructure corporations require more fixed capital than wholesale and retail businesses. It’s utilized for things like business promotion, expansion, and modernization. Because the company’s fixed capital is used to purchase non-current assets such as equipment and machinery, land and buildings, furniture and fixtures, patents, goodwill, trademark, vehicles, copyright, and so on, depreciation is levied on these assets as their value decreases over time.
Working capital is the barometer that measures the soundness of the company’s financial and operational effectiveness. The result of current assets with fewer current liabilities means assets that can be transformed into real money within 1 year such as stocks, debtors, cash, etc., while the current liabilities are the liabilities due to be payable within 1 year, i.e. creditors, bank overdraft, tax allowances, short-term loans, etc.
Difference based on acquiring types of asset
Another difference between fixed capital and working capital is its type of asset. Fixed assets are a form of non-current asset that is long-term, tangible property or equipment that a company owns and uses to produce revenue. In a year they should not be consumed or turned into cash.
Rather than expensed, non-current assets are capitalized, and throughout the number of years in which the asset is used their value is determined and allotted. Companies buy non-current assets for the purpose of exploiting them while their profit lasts for over a year. Depending on its type, the property might be amortized or depreciated.
In general, current assets mean those assets that will be or are anticipated to be converted into cash within one year, in the regular and customary course of business. Current assets, such as money, account receipted for (customer’s outstanding bills), and stocks of raw materials and finished goods and their current liabilities, such as the accounts payable, are different for the working capital, also called the Net Working Controlling Capital (NWC). NWC refers to the liquidity measurement of an organization and the difference between current operating assets and current operating liabilities. The calculations are often identical and are generated from fewer accounts payable, cash plus accounts receivable plus stocks, and less accrued expenses.
Difference based on terms
For more than a year a corporation plans to utilize its fixed assets and benefit from them, making it a “long-term” or “noncurrent ” fixed asset. That is different from the current assets that a company plans to hold for less than a year, such as inventories. For example, you might expect to have it used for 10 years before it is replaced if your small business purchases machinery.
Current assets that are transformed into cash within a short space of time are collected by working capital. While working capital is a short-term capital, it is always and forever needed. Working capital is required to maintain the company’s productivity, as indicated earlier. Therefore, the company will continually need working capital as long as production continues. The permanently needed working capital is known as permanent or regular working capital.
Difference based on liquidity
Liquidity is how quickly an asset may be purchased or sold at a price reflecting its inherent value at the market. In other languages, liquidity is the effectiveness of converting an asset or security into cash without altering its market price. Cash is usually regarded as the most liquid asset as it can be transformed into other assets most rapidly and easily. Tangible assets are all rather illiquid, such as real estate, fine art, and collectibles. Other financial assets, from equities to shareholders, fall in the liquidity spectrum at different locations.
In order to buy fixed assets, fixed capital is used. The liquidity of these assets is poor since they cannot be easily sold. Although fixed assets are generally valued at a level, these assets do not perceive themselves to be extremely liquid. This is because of the limited market for some things, for example, manufacturing equipment and the high price it takes for a fixed asset to be sold, which normally takes a long period.
Fixed capital is less liquid than working capital. If necessary, work capital may be transformed into cash without significant loss in a short period. A corporation in need of cash can transform its working capital by insisting on prompt payment of its bills receivable and speeding up sales of its product. It is because of this feature of working capital that businesses with a greater workforce feel safer.
Difference based on importance
In the start-up of a business, fixed capital is quite important. It is essential for the acquisition of fixed (tangible and intangible) assets, which is a prerequisite for forming a business. Certain businesses (manufacturing and public utilities, for example) cannot function without a sufficient amount of fixed capital. When the concept to open an industrial unit first arises in the head of the entrepreneur, the first investment is made in fixed assets, and only then will the business be able to function properly.
In order to be capable of establishing itself, fixed capital is not just necessary to fund the acquisition of fixed assets. It’s also required for making modifications to and extending a company’s setup. It, therefore, seems to be a fundamental condition for the development of an industrial company where a sufficient amount of fixed capital can be attained.
It is impossible to overstate the importance of adequate working capital in any firm. To run its day-to-day operations smoothly and efficiently, a company needs enough working capital. The absence of adequate capital does not only harm the profitability of the company but also leads to a halt in production and efficiency in the payment of its existing commitments. Efficient management of working capital enables any company to operate smoothly and reimburse maturing debts and costs which may develop in the near future.
Difference based on capital budgeting
Capital budgeting is another difference between fixed capital and working capital. Capital budgeting processes are used to make fixed investment decisions. The budgeting of capital is comparing the cash flows that can be generated during their useful life by a fixed asset investment. This is done with strategies like net current, internal return rate, and reimbursement period. Only when its projected cash inflows exceed cash outflows will a fixed capital investment be accepted. For a specific accountable period or financial year, the operating capital investment budgeting process is based on the projected operational scope.
Difference based on financing methods
The investment of fixed capital is funded by long-term debt while working capital is financed by short-term debt. Short-term debts are loan lines that are refundable within a year, such as bank overdrafts. They are listed on the balance sheet as current liabilities. For extended periods, long-term loans can be repaid. It is included on the balance sheet as long-term liabilities.
Difference based on investment procurement
Work capital investment urgently has to be obtained in order to enable seamless operations. In order to prevent an unnecessary disruption in production activities, a manufacturing company must always maintain enough stocks, for example. Fixed capital investment procurement is a long procedure, particularly when financing from outside sources is involved.
These are a lot of the differences between capital fixed and working capital. It is critical that a company’s management recognizes the differences and maintains a healthy balance between the two. The corporation may have to contend with the music if the ratio from fixed capital to work capital is even slightly off. Any capital discrepancy will force the company to face tremendous challenges and may lead to the liquidation of the company. To prevent this, a company should always be managed by a financial consulting company that helps the company avoid such penalties and helps the company flourish.
A business entity’s important requirement for doing business is capital. After analyzing the preceding factors, it is evident that total capital includes both fixed and working capital. They are not mutually exclusive, but they do complement each other in the sense that working capital is required to utilize a company’s fixed assets, such as plant and machinery if raw materials are not employed in manufacturing. As a result, working capital ensures that the company’s fixed assets are used profitably.