When we look at the capitalised world, we can see numerous companies offering goods and services. You might have a favourite brand for certain products. However, have you ever wondered how these companies began and how they keep themselves in business? To start and establish a company, one needs to make huge investments in certain fixed assets like land, buildings, machinery, etc. These assets make up the fixed capital of that company. After establishment, companies need to hire employees and pay their salaries, pay various bills, pay external suppliers, etc. Companies make all these payments using their assets from working capital.
This article explores the uses and needs of both working capital and fixed capital. It also explains the difference between the two assets.
Working Capital vs Fixed Capital
All companies need a sufficient amount of working capital and fixed capital for their smooth functioning. Working capital refers to a company’s short-term assets. These assets are easily liquefiable. Working capital helps to pay a company’s day-to-day expenses. Companies can liquefy these assets at any time and use them to pay the salaries of employees, pay external vendors or suppliers, buy the necessary materials for everyday functioning, etc. A company needs sufficient working capital to meet its operational goals. Working capital usually lasts for less than one accounting period (or year).
Fixed capital refers to a company’s long-term assets. These assets are not easily liquefiable. For example, assets like property, manufacturing pieces of equipment, etc. They help secure the company’s future. A company needs sufficient fixed capital to meet its strategy-oriented goals. Fixed capital lasts for more than one accounting period (or year)
Difference Between Working Capital and Fixed Capital in Tabular Form
| Parameters of Comparison | Working Capital | Fixed Capital |
| Meaning | A company’s short-term assets | A company’s long-term assets |
| Liquidity | Assets can be liquefied anytime | It is difficult to liquefy |
| Duration | Short-term use | Long-term use |
| Use | Helps with day-to-day expenses | Helps with long-term goals |
| Goals | Operational goals | Strategy oriented goals |
| Accounting period | Usage lasts for less than one accounting period | Usage lasts for more than one accounting period |
| Need | A company needs working capital for keeping its business going, pay dividends, repay loans, increase creditworthiness, increase efficiency, compete with other companies, increase goodwill, etc. | A company needs fixed capital for its establishment, promotion, modernisation, asset replacement, expansion, automation, etc. |
What is Working Capital?
Companies or any organisations usually have day-to-day expenses. These expenses include paying bills, paying employees, and buying everyday materials (stationeries). The money or liquid assets that companies use to pay such expenses are “working capital”. It is the difference between a company’s current assets like cash and their liabilities like debt. Current assets include those assets that a company can liquidate within a year and use for necessary expenses. Current liabilities of a company refer to their short-term loans, creditors, bank overdrafts, tax provisions, etc. Working capital provides companies with short-term financial stability.
Different Types of Working Capital
Working capital has two major classifications based on time and concept.
- Time
- Gross working capital: When a company spends money to buy current assets needed for them, it is gross working capital.
- Net working capital: Often companies take loans for starting the company. Sometimes they may go into debt when they face a sudden financial crisis. After the company becomes financially able, they pay these amounts back to their lenders. When you deduct the current liabilities of a company from its current assets, you get net working capital.
- Concept
- Permanent working capital: permanent working capital consists of assets that require the least investments.
- Temporary working capital: Temporary working capital consists of variable assets. It is fluctuating. This type of asset has more importance than permanent working capital or fixed capital in the running of companies.
Need for Working Capital
Essential To Keep Business Going
Every business has every day payments and long-term payments. A company needs working capital to continue its daily business operations. Working capital helps companies pay their employees and external workers and purchase raw materials. The assets from working capital pay for recurring expenses like electricity, water, power bills, rent, etc.
To Pay Dividend
When companies go public, it allows other people to buy shares of the company. In return, the company pays dividends to the shareholders. The dividend payments occur either yearly or half-yearly. Companies use their assets from working capital to pay dividends to shareholders.
To Repay Loans
Sometimes companies take out loans when faced with sudden financial setbacks. Some other methods are to issue shares or to take out a debenture. Debentures are long-term business loans that do not require collateral. They are a helpful tool when companies experience financial trouble. Companies with strong finances and capable of repaying loans can acquire debentures.
Working capital helps to repay all these loans.
To Increase Creditworthiness
When a company has sufficient working capital, it can repay its loans on time. This gives them a positive reputation with creditors. The companies are reliable and trustworthy. Hence, creditors will be more willing to let the company borrow things like raw materials or money.
Increase Efficiency and Productivity
When a company has sufficient working capital, it can provide better for its employees. They can invest their money in advanced pieces of equipment that will make employees' jobs easier. Companies also gain the money to fund welfare facilities for their employees, give them appropriate training, etc. Hence, a company with adequate working capital increases its employees’ efficiency and productivity.
To Compete Against Other Companies
All markets have several companies offering the same products and services. Hence, a company needs sufficient working capital to compete against other companies. Companies can use assets from working capital to fund advertisements and promotions. They can pay for celebrity endorsements. Companies also use working capital to provide credit terms for customers. Hence, having sufficient working capital is important to fight against competition.
Helps With Seasonal Fluctuations
Working capital helps to keep a company running throughout the year. A company’s sales can experience seasonal variations. For example, a company selling winter clothes may have more customers during the winter season. Thus, a company requires sufficient working capital to make their day-to-day payments during different seasons.
To Increase Goodwill
When companies have good working capital, they can pay their workers on time and provide good working conditions. They are also able to pay their external vendors on time, repay loans, etc. Hence, working capital helps companies earn a good reputation.
Benefits of Working Capital
- Helps a company pay off long-term debts.
- When a company has sufficient working capital, it can make timely payments to its suppliers and creditors. This increases their creditworthiness.
- Having good creditworthiness can increase a company’s chances of getting a sudden loan when they are in trouble.
- Sufficient working capital helps companies to make upfront payments when purchasing supplies. This helps them to avail of cash discounts.
- Sufficient working capital helps insulate a company against future uncertainties and financial crises.
- Sufficient working capital allows companies to respond quickly to favourable market conditions. Companies can make large purchases when the prices of raw materials fall. Companies can also produce more products when demand for their products increases.
- Working capital is useful for making investments.
- Sufficient working capital helps companies to give timely salaries to their employee. Hence, increasing efficiency and fostering a good work culture.
What is Fixed Capital?
While it is necessary to have assets to pay for day-to-day expenses, companies also need long-term assets. These include a property for the company to run from (land, building), equipment to produce their products, furniture, fixtures, etc. These kinds of long-term assets that keep a company running for years, are "fixed capital”. Hence, every company compulsorily needs fixed capital.
Need for Fixed Capital
Establishing a Company
Fixed capital is what helps companies begin their journey. Every company requires a place to run its business. If companies are offering manufactured products, they require the necessary equipment to produce their products.
The maximum amount of fixed capital investment happens during the initial stages of a company’s establishment.
After establishment, a company requires fixed capital to purchase other long-term assets that keep the company functioning for long periods.
Promoting a Company
After buying property, and equipment, and hiring staff, a company needs to make itself known. If people are not aware of a company, they will not buy its products. Therefore, companies need to promote themselves. A company needs to inform people of its existence, the products and services it offers, its authorization, etc.
One way to gain more people is by promoting. A company requires fixed capital to pay for promotional activities.
Modernising a Company
All companies need to improve with the changing times. Traditional equipment might have worked well in the past, but if a company wants to keep up with their competitors and stay in the market, they need to upgrade themselves.
Modernising a company involves buying new machinery and technologies. It also involves keeping up with the current trends. Modernising a company helps to decrease the workload of a company’s employees. Hence, it can help to increase efficiency and productivity.
A company requires adequate fixed capital to invest in modernisation equipment.
Replacing Outdated Assets
Over time a company's equipment like plants, machinery, furniture, etc becomes worn out. Once the equipment has worn out, they cannot produce with as much efficiency as before. Hence, a company has to replace them with new equipment for its smooth functioning.
To replace their outdated assets, companies require a sufficient amount of fixed capital.
Expanding a Company
Companies need to expand their reach to grow. Expanding a company means reaching new levels within the same sector.
Companies use fixed capital to finance their expansion.
Diversifying a Company
After expanding in one sector, companies can branch out and capture other areas of the market. Diversifying a market means growing a company’s business by working in different sectors of the economy.
For diversification, a company requires fixed capital assets.
Automating a Company
In the modern world, there are more and more technologies that can help reduce a company’s dependency on manual labour. Companies can automate themselves by purchasing self-operating machinery. Self-operating machinery is often expensive and requires large spaces to operate. Hence, a company requires fixed capital to meet the demands of automation.
Fixed Capital Depreciation
The value of different fixed capital varies. Some fixed capital undergoes depreciation quickly, while others stay for a long time. For example, fixed capital like manufacturing equipment may depreciate faster than properties.
Company owners can use the depreciation method to decide where to invest more money. It also helps them realise the value certain fixed capital provides to the company.
Liquidating Fixed Capital
Most fixed capitals like not easily liquefiable. This is because the sale of such assets takes long durations because of their high price and maintenance. For example, selling property requires meeting a buyer with that extra money. It is hard to find a buyer to sell huge compounds of your company’s property.
Main Difference Between Working Capital and Fixed Capital (in Points)
- The short-term assets that help to keep a company running ever day is working capital. In contrast, the long-term asset needed for the company to last throughout the years is fixed-capital.
- Working capital provides income for the day-to-day expense of a company, like paying workers, sellers, etc. Fixed capital ensures the company’s future.
- A company can liquefy their working capital anytime to meet the company’s financial requirements. In contrast, fixed capital is hard to liquidate since they are mostly huge areas of property or manufacturing equipment.
- Working capital usually lasts less than one accounting period (or year). In contrast, fixed capital lasts for more than one accounting period.
Conclusion
In short, working capital and fixed capital are essential assets for any company or institution. A company needs adequate fixed capital to establish itself and continue business for the long term. Without fixed capital, a company will not be able to last for years. After establishment, a company requires working capital to keep it running smoothly. Without working capital, a company will not be able to make its day-to-day payments.
References
- https://www.pinelabs.com/blog/difference-between-fixed-and-working-capital
- https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-guides/glossary/debenture
- https://www.fullertonindia.com/knowledge-center/working-capital-meaning.aspx
- https://kalyan-city.blogspot.com/2012/10/explain-role-or-importance-of-fixed.html
