Importance of Understanding the Difference Between Fixed and Working Capital

Importance of Understanding the Difference Between Fixed and Working Capital

Managing a small business is like getting yourself on-the-job training in every department in your company. Every entrepreneur like yourself is expected to learn all the ins and outs of your business, even if you don’t plan to go hands-on in some of those aspects.

Capital management is one of those subjects you must build sufficient knowledge of. A close look at your finances will reveal that your business has two kinds of capital. These are, namely, the fixed and working capital. Understanding the difference between the two is crucial to effectively manage your short-term and long-term finances.

How Knowing the Difference Between Working and Fixed Capital Helps Your Management

When you understand what sets working capital apart from fixed capital, you’ll be able to also do the following:

  • Recognize if the business is having problems in its day-to-day operations
  • Decide if the company needs to seek financing like invoice financing and other loans.
  • Determine if the enterprise can keep up with its financial obligations like short-term debts
  • Identify ready sources of cash that your business can collect on and when
  • Know what assets are there to benefit you for the long-term

In other words, understanding which assets make up your working capital will help you understand the financial health of your business within the short term. With this knowledge, you can seek out financing to correct any short-term working capital problems before the situation worsens.

What Makes Up Your Working Capital?

Your working capital is the difference between your current liabilities and current assets. Current assets are holdings that you expect to become cash within the next year. These are short-term sources of income like invoices or accounts receivables, stock or inventory, and cash on hand. On the other hand, current liabilities are debts that you are expected to settle within the year.

To determine the value of your working capital, simply deduct your current liabilities from your current assets. Working capital can both be a positive and negative number. Of the two, the negative working capital can be a cause of alarm. It means that the company’s short-term financial obligations far exceed what resources it has to keep up with its current liabilities.

Having a negative working capital does not always mean a problem. Some businesses may have long-term receivables from their customers or clients that are not considered as current assets. In this case, the negative figure indicates that the company’s financial obligations and sources of income are not balanced.

What Is Fixed Capital?

Fixed capital, on the other hand, is the total of long-term investments that the business needs to get itself off the ground.

For example, manufacturing companies will invest in long-term leases of equipment and commercial property. Tech companies should have invested considerably in patents to protect their inventions as well as the facilities needed to create their products. The capital investment to fund these acquisitions makes up the business’ fixed capital.

The fixed assets, whether tangible or intangible, are valuable for the long-term operation of the business. The company may choose to liquidate these fixed assets if they no longer serve a useful purpose in the organization. However, entrepreneurs don’t expect to convert these assets into cash within a year.

Unlike current assets, fixed assets also depreciate in value over time. Businesses cannot expect to turn in a profit when liquidating these assets. However, they can deduct the yearly depreciation from their annual income taxes.

Having a solid knowledge of what makes up your fixed and working capital is vital to making timely and informed decisions on short-term financial concerns. Knowing how to determine your working capital makes you more proactive; you can easily keep up with your current liabilities by taking out financing right when you need to.

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