Capital is any type of asset, including physical or financial, that is used to generate value through products and services. It can be divided into two types, working capital and fixed capital.
- Fixed capital is any asset that is used for long-term growth and is a non-liquid asset. It is not intended to be sold and used to produce a product or service, cannot be fully used or converted into cash in a single accounting period, and is used for long-term productivity. Some assets like software and patents may be considered fixed capital or intangible assets depending on your accountant.
- Working capital is the liquid assets including cash, accounts receivable, inventory and other assets that can be converted to cash quickly, and is used to fund day-to-day operations to keep the company operational. It can be calculated by subtracting current liabilities from current assets.
Both fixed and working capital are needed for a business to be successful, and they have some crossover. Your fixed capital can be a conveyor belt or assembly line and a machine that produces a product, while your working capital will cover the cost of the materials you use to produce the product and the employees that work on the assembly line.
Equipment financing can be used to purchase fixed capital like a machine to expand manufacturing so the business can increase output, while a working capital loan can increase your working capital to pay for the materials and labor the fixed capital uses to increase production.
Here is some more information on what each one is, and how both help your company succeed by growing your revenue for the short and long term.
What Fixed Capital Is
Fixed capital includes any long-term physical or non-physical asset a company invests in that can produce revenue or income repeatedly over multiple years. As long as the asset is not used in a single transaction or accounting period, it is likely fixed capital.
Examples of fixed capital include:
- The land the company owns and the buildings on top of it.
- Machinery, equipment, and vehicles.
- Technology including computers, infrastructure and systems.
- Solar panels, battery storage systems, and wind turbines.
- Display and retail fixtures, furniture in a restaurant or hotel, point of sale systems, and the equipment in a gym
There can be some assets that are for long term growth like your domain name or a trademark, but may be considered an intangible asset rather than fixed capital as they are not physical assets.
The same goes with investment accounts that are not being held for long term and will clear or that can be liquidated in an accounting cycle, even though they can grow in time with dividend payouts. While there may be a physical piece of paper you can print, the actual asset is not physical.
Raw materials are also not fixed capital as they are used to produce goods and services and move in a regular business cycle. This makes the raw materials working capital while the machinery used to produce them is fixed capital.
What Working Capital Is
Working capital is the money that a business has to cover day-to-day operations, or the assets the company is planning on converting to cash in a single accounting cycle, and is found by subtracting current liabilities from current assets.
Working Capital = Current Assets – Current Liabilities
If you’re a cheese and bread shop with $10,000 in cash, $2,000 in bread, and $3,000 in cheeses, you have $15,000 in current assets. When there are bills owed like $1,000 for flour and $500 for rent or utilities, and $500 for wages, your business has $2,000 in current liabilities. This means your working capital is $13,000 and you have plenty of room to operate.
When this same bakery has $10,000 in cash but increases bread and cheese to $5,000 and $8,000 for the holiday season, they now have $23,000 in current assets. The cost to produce the bread and cheese may have increased, and so did salaries and utilities. Let’s also pretend you needed to take a business loan to replace an oven that costs $15,000 and has to be paid in full within 12 months. This increases the total amount of current liabilities to $28,000. Your company is now going to struggle to operate.
With that said, this number could be misleading. If holiday demand spikes and you have extra raw materials, you may be able to clear your current inventory, produce more bread and cheese, and pay off the debts during the busy season as sales will spike. But this is only if there is a busy season rush.
Examples of assets that are working capital are:
- Cash and cash equivalents including checking and savings accounts or treasury bills.
- Accounts receivable, trade credit, and tax refunds.
- Inventory including ready-to-sell products on a shelf and the raw materials used to manufacture goods.
- Prepaid expenses like rent, utilities, software, and prepaid advertising spaces.
- Short-term loans you provide vs. take, including loans to customers and advancing an employee’s salary.
Examples of current liabilities are:
- Accounts payables including utilities and rent you owe monthly payments.
- Any outstanding invoices or payments owed to vendors, suppliers, and lenders.
- Short-term business loans that have payment periods less than 12 months like a business bridge loan or the balance on a business line of credit.
- Taxes your business owes on including estimated, payroll withheld, and property for the land your company owns.
- Gift cards your customers purchased, ticket sales for upcoming events or travel (tours or concerts), and other unearned forms of revenue.
By adding up your current assets and current liabilities you’ll be able to calculate your working capital. If you fall short and need a cushion to keep operations running, working capital loans like a payroll loan could be a solution.
Working capital and fixed capital are both types of assets that a business needs to succeed. Fixed capital is your long-term assets that produce value over the long run while working capital is meant to produce cash within a single accounting cycle.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
