Every big or small entity essentially requires funds to run its business smoothly and continuously. Funds are needed at all stages of the business right from formation of the entity to running its day to day operations to its expansion and growth plans. This funding raised and utilized by a business is referred to as ‘capital’.
This article looks at meaning of and differences between the two different forms of capital – working capital and fixed capital.
Definitions and meanings
Working capital
Working capital is the funds utilized for running the day to day operations of the business.
Example – In the case of a manufacturing company, funds are needed for purchasing raw materials, payment of wages and for other production utilities. Funds are also needed for utility expenses such as rent, electricity and multiple other day to day running expenses. The funds utilized for all these expenses qualifies as working capital.
Working capital is calculated by applying the following formula-
Working capital = Current assets minus current liabilities
A good working capital ratio is in the range of 1 to 2 which can indicate that the entity has sufficient funds to meet its operational obligations. A ratio lower than 1 is not considered optimum as it indicates that the company has to resort to external funding to run its operations. On the other hand, an excessively high ratio, above 2 is also not optimum as it may indicate that the entity has excess idle funds or that it has too much funds locked in inventory.
Working capital is thus an indication of an entity’s operating liquidity as well as its short term financial condition.
Fixed capital
Fixed capital is the funds utilized to acquire assets which are applied in the business over a longer time period. These are generally non-current fixed assets which serve as resources for generating long term revenue for the entity.
Fixed capital is required at the time of commencing business operations as well as at the time of any expansion, growth or revamping of the business.
Example – Fixed capital is generally used to acquire tangible fixed assets such as plant and machinery, furniture etc as well as intangible assets such as trademarks, payments etc.
The amounts involved in fixed capital funding are generally high. Fixed capital is thus typically sourced through external sources such as debt or equity.
Several analytical ratios related to fixed capital are calculated and analysed by management from time to time. One such ratio is the fixed capital turnover ratio which indicates the ability of the business to generate sales through its investment in fixed assets.
Difference between working capital and fixed capital
The difference between working capital and fixed capital has been detailed below:
1. Meaning
- Working capital is that part of funds of an entity used for operational expenses of the business.
- Fixed capital is that part of the funds applied to purchase long term assets which are used in the business over a long run.
2. Utilized for
- Working capital is utilized for payments related to day to day operations such as raw materials, wages, rent and other utilities.
- Fixed capital is utilized for purchasing various fixed assets such as plant and machinery, equipment, furniture, vehicles etc.
3. Time period over which it is utilized
- Working capital is utilized for short term requirements – consumables which are generally utilized within the same accounting period.
- Fixed capital is utilized for long term requirements – durables which are utilized across several years and hence across different accounting periods.
4. Frequency of requirement
- Working capital is required frequently as it is used for day to day operations.
- Fixed capital is required less frequently as it is needed at the time of commencement of business and at the time of any subsequent growth or expansion.
5. Source of funds
- Entities prefer to generate working capital through internal sources i.e.: funds generated through its operations. External sources are resorted to where funds generated through operations are not sufficient.
- Fixed capital is higher in value and is generally raised through external sources such as raising loans or equity.
6. Ability of conversion
- Working capital consists of current assets which are more liquid and can be converted into cash more easily.
- Fixed capital consists of non-current assets which are relatively illiquid and tougher to convert into cash.
7. Purpose
- Working capital serves operational purpose.
- Fixed capital serves strategic purpose.
Working capital versus fixed capital – tabular comparison
A tabular comparison of working and fixed capital is given below:
|
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| Meanings | ||||
| Funds applied in the day to day operations of the business | Funds applied to purchase long term revenue generating assets | |||
| Utilized for | ||||
| Day to day operations | Acquiring fixed assets | |||
| Time period over which it is utilized | ||||
| Short term period – generally within the same accounting period | Long term period – generally across multiple accounting periods | |||
| Frequency of requirement | ||||
| Very frequent | Less frequent | |||
| Sources of funds | ||||
| Internal or external short term loans | External sources such as taking loans and raising equity | |||
| Ability of conversion | ||||
| Liquid – easily convertible to cash | Illiquid – tougher to convert to cash | |||
| Purpose | ||||
| Operational | Strategic | |||
Conclusion – working capital vs fixed capital
Both working capital and fixed capital are important to keep a business running as well as to keep it on a positive growth path. Management of business entities tend to focus equally on managing both working capital and fixed capital requirements. Ratios related to working capital and fixed capital are extensively used to analyse the financial condition of a businesses.
