Profit and loss are major elements of any business, regardless of its industry. Both of these elements are dependent on the assets of the company. Another term to refer to these assets is capital.
Capital is one of the most important resources for any business. If a business does not have capital, it cannot exist or be run. The two major types of capital in any organisation are fixed capital and working capital.
Let’s take a closer look at these two types of working capital and their requirements.
Fixed capital
Fixed capital includes capital investments, such as plant, property, and equipment (PP&E), and assets. This capital is required to start up and conduct business, even when it is only at the beginning stages. Machinery, factory, vehicles, etc., are other more basic examples of fixed capital.
These assets are reusable, i.e., they are not destroyed or consumed during the production of a service or goods. Thus, these assets can help the business for more than one accounting period.
These assets are depreciated overtime on the company’s accounting statements. It takes a long period and can even continue for up to 20 years. The assets are not easily liquidated (turning to cash). However, they can be resold and reused whenever desired.
Factors determining requirements of fixed capital
Some of the factors that affect the requirements of fixed capital are:
Growth Prospects
Companies with higher growth plan still expanding require more fixed capital. This is because they need more machinery and plants to increase their production capacity.
Diversification
Businesses planning to diversify their activities (including more products) will require more fixed capital than those who aren’t planning diversification.
Joint Ventures
Companies that collaborate with other companies can share their plants and machinery and thus have lower fixed capital needs. Companies that operate on their own will have higher fixed capital needs.
Production techniques
Companies that employ labour-intensive techniques will need less capital, but companies with capital-intensive techniques will need more fixed capital for their plant and machinery needs.
Working capital
Working capital, also known as networking capital (NWC), is the difference between a company’s current assets (what they already own) and their current liabilities (what they owe). Current assets can be finished goods, raw materials inventory, cash, unpaid bills, etc. Current liabilities include debts and accounts payable.
Working capital serves the business on a day-to-day business. It helps measure operating efficiency, liquidity, and short-term financial health. Companies with positive NWC (more assets than liabilities) are likely to grow, while companies with negative NWC (more liabilities than assets) may cease growing and even go bankrupt.
However, it is important to note that high HWC is not always positive. It may indicate the business’s inability to invest extra cash or have more inventory than required. Working capital includes money market funds, treasury bills, bonds, stocks, mutual funds, etc.
Factors determining the requirements of working capital
Many factors affect the requirements of working capital. Some of these are as follows:
Nature of business
Working capital needs vary from industry to industry. Companies in the manufacturing sectors have higher working capital needs than companies in the service industries. Thus, according to your business, your needs will vary.
Raw material availability
Companies that use seasonal raw materials will need to store large quantities of the same, resulting in higher working capital needs. Those that use readily available raw materials will have lower needs.
Operating efficiency
Operating efficiency is how long it takes to convert raw materials to finished goods, sell the goods, and collect payments. Whereas high-efficiency businesses have lower needs, low-efficiency businesses will have high needs.
Competition level
When there’s high competition in the market, there is a greater need to supply goods on time. Larger inventories are required and thus more working capital as well. Companies with a monopoly or low competition can establish their terms and not need as much working capital.
Difference between fixed capital and working capital
Basis for Comparison | Fixed capital | Working capital |
Definition | Fixed capital is the investments businesses make to acquire long-term benefits. | Working capital is the capital used by the company in its day-to-day operations. |
Liquidity | Not liquid. | Very liquid. |
Conversion to cash | It cannot be converted to cash | It can be converted to cash |
Time period | Helps the business gain long-term benefits. | Helps the business in the short term. |
Accounting Period | Benefits last for longer than one accounting period. | Benefits are for less than one accounting period. |
Types of assets acquired. | Helps in acquiring non-current assets of the business. | Helps in acquiring current assets of the business. |
Objective | Strategic | Operational |
Consumption | As they aren’t directly consumed and have reusable value, they benefit the business indirectly. | Working capital is crucial for the business to operate successfully. |
Risk factor | High | Low |
Conclusion
Fixed capital and working capital are both necessary for a business to succeed. Both are equally important for a business to run successfully and grow and expand. It would be incorrect to consider only one important and not so much.
Whereas without fixed capital, you cannot start a business, insufficient working capital will make it near impossible for you to run the business. If special attention isn’t given to both, the business will face a tough time surviving.
Thus, the assets – or the capital – the business invests in is very important for its longevity. These assets must be appropriate for the business to reap its benefits and survive for years to come.
