Fixed Capital and Working Capital

A firm requires funds to acquire two types of assets : fixed assets and current assets . Fixed assets include land biulding , plant, and machinary , vehicles , equipment etc. These assets relatively permanent in nature and are necessary for carrying on the bussiness. Current assets ,on the other hand ,are kept for supporting day-to-day operations and keep changing during the course of the business.They liquidated within short period of time during the operating cycles of the industry and not normally exceeding one year.

Current assets include cash , debtors, inventory of raw materials and finished goods , etc. Current assets constitute gross working capital.

Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business. No business can run successfully with out an adequate amount of working capital.Meaning of working capital: Working capital refers to that part of firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors, and inventories.

In other words working capital is the amount of funds necessary to cover the cost of operating the enterprise. Working capital means the funds (i. e. ; capital) available and used for day to day operations (i. e. ; working) of an enterprise. It consists broadly of that portion of assets of a business which are used in or related to its current operations.

It refers to funds which are used during an accounting period to generate a current income of a type which is consistent with major purpose of a firm existence.

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Objectives of working capital: Every business needs some amount of working capital. It is needed for following purposes,for the purchase of raw materials, components and spares. To pay wages and salaries. To incur day to day expenses and overhead costs such as fuel, power, and office expenses etc. To provide credit facilities to customers etc.

Factors that determine working capital: The working capital requirement of a concern depend upon a large number of factors such as Size of business, nature of character of business, seasonal variations, working capital cycle, operating efficiency, profit level, Other factors. Sources of working capital: The working capital requirements should be met both from short term as well as long term sources of funds. Financing of working capital through short term sources of funds has the benefits of lower cost and establishing close relationship with banks. Financing of working capital through long term sources provides the benefits of reduces risk and increases liquidity.

The number one reason most people look at a balance sheet is to find out a company’s working capital (or “current”) position. It reveals more about the financial condition of a business than almost any other calculation. It tells you what would be left if a company raised all of its short term resources, and used them to pay off its short term liabilities. The more working capital, the less financial strain a company experiences. By studying a company’s position, you can clearly see if it has the resources necessary to expand internally or if it will have to turn to a bank and take on debt.

Working capital ManagementWorking capital is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as DCFs (Discounted cash flows).

If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.Long-term Debt A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. Calculation Current assets and current liabilities include three accounts which are of special importance.

These accounts represent the areas of the business where managers have the most direct impact:

• accounts receivable (current asset)
• inventory (current assets),
• accounts payable (current liability).

The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit.An increase in working capital indicates that the business has either increased current assets that is has increased its receivables, or other current assets or has decreased current liabilities, for example has paid off some short-term creditors. Cash balance items often attract a one-for-one purchase price adjustment. Working Capital is the easiest of all the balance sheet calculations. Here’s the formula.

Current Assets – Current Liabilities = Working Capital

Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can’t pay its monthly bills.Under the best circumstances, poor working capital leads to financial pressure on a company, increased borrowing, and late payments to creditor – all of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate, which can cost a corporation a lot of money over time. Component of working capital are cash, inventory, account payable, market securities and loan from bank. Net working capital is defined as the difference between current assets and current liability.

Thing for High Turn Businesses Companies that have high inventory turns and do business on a cash basis such as a grocery store need very little working capital. These types of businesses raise money every time they open their doors, then turn around and plow that money back into inventory to increase sales. Since cash is generated so quickly, managements can simply stockpile the proceeds from their daily sales for a short period of time if a financial crisis arises.Since cash can be raised so quickly, there is no need to have a large amount of working capital available.

A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they can’t raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for short-term financial crises by the time it is sold, it may be too late.It’s easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties.

Fixed capital It refers to any kind of real or physical capital (fixed asset) that is not used up in the production of a product and is contrasted with circulating capital such as raw materials, operating expenses and the like. Fixed capital is that portion of the total capital that is invested in fixed assets such as land, buildings, vehicles and equipment that stay in the business almost permanently, or at the very least, for more than one accounting period.Fixed assets can be purchased by a business, in which case the business owns them, but also leased, hired or rented, if that is cheaper ,more convenient, if owning the fixed assets is practically impossible. Whether an assets is a fixed asset or not depends on the purpose for which it is held.

For example, the land on which a company’s factory is built is its fixed asset. However,if it plans to use land for property development, it will be a current asset. So the intention of the owner in holding an asset determines its classification as a fixed or a current asset.Fixed assets,also reffered to as long – lived assets,are often divided into several categories:

• Tangible assets. These are fixed assets that have physical existence and can be seen and felt, including land, building, plant, equipment,and vehicles. Property, plant and equipment is another term for tangible things assets.
• Intangible assets. Unlike tangible assets, these have no physical existence, rather, they represent, legal rights or economic benifits. Trademarks, patents, franchises, copy rights, and goodwill are examples of intangible assets.
• Natural resources. These constitute a category by themselves because of their special charecteristics. Examples are oil and gas wells, mines, and forests. accounts for fixed assets involves the following issues, Determining the cost of acquisition of fixed assets, allocating the cost of fixed asstes, accounting for disposal of fixed assets.

Refining the classical distinction between fixed and circulating capital in Das Kapital, Karl Marx emphasizes that it is really purely relative, i. e. efers only to the comparative rotation speeds (turnover time) of different types of capital assets. Fixed capital also “circulates”, except that the circulation time is much longer, because a fixed asset may be held for 5, 10 or 20 years before it has yielded its value and is discarded for its salvage value. A fixed asset may also be resold and re-used, which often happens with vehicles and planes.

In national accounts, fixed capital is conventionally defined as the stock of tangible, durable fixed assets owned or used by resident enterprises for more than one year.This includes plant, machinery, vehicles ; equipment, the value of land improvements, and buildings. The European system of national and regional accounts explicitly includes produced intangible assets e. g. mineral exploitation, computer software, copyright protected entertainment, literary and artistics originals within the definition of fixed assets.

Land itself is not included in fixed capital even though it is a fixed asset, because it is not a product or a reproducible good.But the value of land improvements is included Attempts have been made to estimate the value of the stock of fixed capital for the whole economy using direct enterprise surveys of “book value”, administrative business records, tax assessments, and data on gross fixed capital formation, price inflation and depreciation schedules. Using the so-called “perpetual inventory method”, one starts off from a benchmark asset figure, and adds on the net additions to fixed assets year by year, while deducting annual depreciation, all data being adjusted for price inflation using a capital expenditure price index.

In this way, one obtains a time series of annual fixed capital stocks. However, it is widely acknowledged that it is extremely difficult to obtain any accurate measurement of the value of fixed capital, especially because even the owner himself or herself may not know what assets are currently “worth”. Some valuations for fixed assets may refer to historic cost (acquisition cost) or book value, others to current replacement cost, current sale value in the market value. The depreciation write-off permitted for tax purposes may also diverge from so-called “economic depreciation” or “real” depreciation rates.

Economic depreciation rates are calculated on the basis of the observed average market prices that depreciated assets at different ages actually sell for. Sometimes statisticians try to estimate the average “service lives” of fixed assets as a basis for calculating depreciation and scrap values, based on the observed length of time that fixed assets are actually held and used by their owners.

The cost of fixed assets compromises its purchases price, import duties and taxes on purchase, and any directly atributable costs of bringing the asset to working condition for its intended use.The cost of excludes taxes that will be refunded by the government, such as CENVAT adjustment for acquiring the asset and and duty drawback. Trade discounts and rebates are dedeucted in arriving at the purchase price. The directly atributable cost includes, stamp duty and registration fees for transfer of title to land or building, lawyer’s fees, commision and brokerage for purchase, cost of site preparation,Freight transit insurance,initial delivery and handaling costs,installation costs,such as special foundations for plant and professional fees,e. fees of architecture.

As a rule expenditure that result in future economic benifits are added as part of the asset’s cost,or capitalised,while expenditures that do not result in improving the service potential of the asset are changed to current income . For example, a company should capitalize the custom duty paid on machine because it is necessary part of the cost of the machine. But if a machine is damaged during installation, the company should not capitalize the cost of repairing it.

When a business gets assets by donation, such as land given free or at a nominal price by government, there is no cost of acquisition to the business,then donated assets should be shown at zero values. But to record them at zero value does not reflect the economic reality of an increase in an enterprises assets,that donated assets be recorded at a nominal value,and does not permit recording them at their fair value. apital expenditure for the purchase or expansion of fixed assets, and revenue expenditures are for ordinary repairs, maintenance, or fuel, Misclassification of expenditures can distort reported profits. Account for the discarding, sale, or exchange of depreciable assets.

When an assets is discarded, sold, or exchanged for a new assets, the cost are removed from the books, and a gain or loss on disposal is recognised. Intangible assets such as goodwill and brands are becoming important in many industries. Accounts record these at cost and amortize them over their useful lives.Enterprises usually expensed R and D costs, but if they can demonstrate the technical and commercial feasibility of the potential product or process, they can amortize them.

All software-related costs are expensed until the product has been proved to be technologically feasible. Investment risk of fixed capital A business executive who invests in or accumulates fixed capital is tying up money in a fixed asset, hoping to make a future profit. Thus, such an investment usually implies a risk. Sometimes depreciation write-offs are also viewed partly as a compensation for this risk.Often leasing or renting a fixed asset such as a vehicle rather than buying it is preferred by enterprises because the cost of using it is lowered thereby, and the real owner may be able to obtain special tax advantages.

The difference between working capital and fixed capital is as follows:

• fixed capital is used 2 buy fixed assets like land and building. working capital is used to carry out day to day operations.
• fixed capital consists of land ,building,tools,machines etc. working capital consists of cash,marketable securities,accounts receivable,stock etc.
• fixed capital includes long term financial decisions but working capital includes short term financing decisions.
• fixed capital is mainly required for operational activities where as working capital is required for trading activities.

Working capital is not the same as fixed capital. Actually, working capital has different features. Working capital is used to obtain current assets which will turn into cash in a short period. Fixed capital, however, makes reference to the funds that are locked in long term assets.The duration of the working capital depends on the length of production process, the time it takes to sell the product and the time you have to wait in order to receive the cash. Another characteristic of working capital is that is turned into cash, and again into working capital all the time. Working capital is always needed, even when it is a short term capital.

The requirement of working capital varies directly with the level of production. working capital is more liquid. Fixed capital is invested in long term assets so it is necessary to adopt various systems of estimating depreciation.But, with working capital it is not necessary to adopt special accounting system for them. Advantages of working capital: One of the main advantages of looking at the working capital position is being able to foresee any financial difficulties that may arise.

It helps the business concern in maintaining the goodwill. It can arrange loans from banks and others on easy and favourable terms. It enables a concern to face business crisis in emergencies such as depression. It creates an environment of security, confidence, and over all efficiency in a business.It helps in maintaining solvency of the business. Advantages of Fixed capital Fixed assert turn over is a measure of a firm’s effiency in utilizing its fixed assets. A high turnover indicates that the firm is able to generate a lot of revenue per rupee invested in fixed assets. A business can increased its revenu from sales or services by adding fixed capital.

CONCLUSION

Every company wants to invest smaller amounts as working capital and large or long and as fixed capital, but it must be adequate as well to run the business smothly.Thus it is a means to achive the common obiectives of the business to decide the adequate amount of working capital and fixed capital, indicatibg that all the current assets and the part of the fixed capital are financed with long term credit. It is actually the position in a number of corporate enterprises operating in india.