Key Difference – Fixed Capital vs Working Capital
The key difference between fixed capital and working capital is that fixed capital refers to long-term investments that are not consumed during the production process whereas working capital deals with short-term liquidity (how conveniently an asset can be converted into cash) position in a company. Both these types of capitals are very important in a business context and should be managed effectively to gain wider benefits.
CONTENTS
1. Overview and Key Difference
2. What is a Fixed Capital
3. What is a Working Capital
4. Side by Side Comparison – Fixed Capital vs Working Capital
5. Summary
What is Fixed Capital?
Fixed capitals are assets and capital investments that are not consumed during the production process, and they have a residual value (the value at which the assets can be sold at the end of the economic useful life). Property, plant, specialized equipment and machinery are examples of fixed capital. The owners have to invest in such capital investments at the very beginning of the company in order to establish a business with trading ability.
The requirement for fixed capital varies from one company to another as well as the nature of the industry. For instance, firms in highly technical industries such as oil exploration and telecommunication require significant fixed capital bases compared to service-related firms.
What is Working Capital?
Working capital is a measure of both a company’s liquidity and short-term financial robustness. Working capital is essential to run routine business operations since liquidity is considered important for short-term business viability. Working capital is calculated as per below.
Working Capital = Current Assets / Current Liabilities
This calculates the company’s ability to pay off its short-term liabilities with its current assets. The ideal working capital ratio is considered to be 2:1, meaning there are 2 assets to cover each liability. However, this can vary depending on the industry standards and company operations. The following ratios are also calculated to obtain an understanding regarding the working capital situation of the company.
| Working Capital Ratio | Description |
|
(Current Assets – Inventory / Current Liabilities) |
This is quite similar to the working capital ratio. However, it excludes inventory in its calculation of liquidity since inventory is generally a less liquid current asset compared to others. The ideal ratio is said to be 1:1, however, this depends on industry standards just as with working capital ratio. |
|
Accounts Receivable Days (Accounts Receivables / Total Credit Sales * 365)
|
The number of days the credit sales are outstanding can be calculated using this formula. The higher the number of days this indicates possible cash flow issues since customers take longer to pay. |
|
Accounts Receivable Turnover (Total Credit Sales / Accounts Receivables)
|
Accounts receivable turnover is the number of times per year that a company collects its accounts receivable. The ratio is intended to evaluate the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner. |
|
Accounts Payable Days (Accounts Payables /Total Credit Purchases * 365)
|
The number of days credit purchases are outstanding can be calculated using this formula. The higher the number of days, this indicates that the company is taking more time to settle debts to customers. |
|
Accounts Payable Turnover (Total Credit Purchases / Accounts Payables)
|
Accounts payable turnover is the number of times per year that a company settle debts to its suppliers. The ratio is intended to evaluate the ability of a company to efficiently settle credit to its customers in order to maintain positive relationships with them. |
|
Inventory Days (Average Inventory /Cost of Goods Sold* 365) |
This ratio measures the number of days the company will take to sell the inventory. Since this directly relates to sales revenue this shows how successful the main business activity is. |
|
Inventory Turnover (Cost of Goods Sold /Average Inventory) |
Inventory turnover ratio indicates how efficiently inventory is managed by calculating how many times the inventory is sold during the year. |
Figure 01: Working Capital Cycle
What is the difference between Fixed Capital and Working Capital?
Fixed Capital vs Working Capital |
|
| Fixed capital refers to long-term investments that are not consumed during the production process. | Working capital deals with short-term liquidity |
| Investment | |
| Investment in fixed capital is long term. | Investment in working capital is short term. |
| Transposing vs Non-transposing | |
| The major portion of the investment in fixed capital is done at the incorporation of the business. | Investments in working capital occur in limited amounts more frequently. |
Summary – Fixed Capital vs Working Capital
The difference between fixed capital and working capital predominantly depend on the investment and usage of fixed and current assets. While investments in fixed capital are costly than variable assets, the related benefits last longer than working capital assets as well. The role of working capital is cyclical in nature where funds should always be maintained at an acceptable level in order to run smooth business operations.
References
1. Picardo, CFA Elvis. “Working Capital.” Investopedia. N.p., 23 Aug. 2016. Web. 23 Mar. 2017.
2. “Fixed Capital.” Investopedia. N.p., 29 Mar. 2008. Web. 23 Mar. 2017.
3. Jonlen J.R. DeSa, Asst Professor Follow. “CLASSIFICATION OF CAPITAL BY ASST PROF. JONLEN DESA.” LinkedIn SlideShare. N.p., 11 July 2015. Web. 23 Mar. 2017.
4.”Liquidity Ratios | Example.” My Accounting Course. N.p., n.d. Web. 23 Mar. 2017.
Image Courtesy:
1. “y2cary3n6mng-u6yp2j-the-operating-cycle” by Peter Baskerville (CC BY-SA 2.0) via Flickr