Fixed and working capital

The essentials

Fixed capital is the money invested in long-term assets such as land, buildings, plant and machinery. Decisions about it are capital budgeting decisions and are usually large and hard to reverse. Working capital is the money needed for day-to-day operations. Net working capital = current assets − current liabilities. Current assets include cash, debtors, bills receivable and stock; current liabilities include creditors, bills payable and short-term loans.

Key points

• Factors affecting fixed capital: nature of business (a manufacturing firm needs more than a trading firm), scale of operations, choice of technique (capital-intensive needs more), technology upgradation, growth prospects, diversification, financing alternatives (leasing reduces the need), and level of collaboration (sharing facilities).
• Factors affecting working capital: nature of business, scale of operations, business cycle (more in a boom), seasonal factors (more in peak season), production cycle (a longer cycle needs more), credit allowed to customers (liberal credit needs more), credit availed from suppliers (more credit needs less), operating efficiency, availability of raw material, growth prospects, level of competition, and inflation (rising prices need more).
• Example: if current assets are ₹8,00,000 and current liabilities are ₹5,00,000, net working capital is ₹3,00,000.

Exam tips

• A trading concern needs less fixed capital but relatively more working capital; a manufacturing firm needs more fixed capital.
• Liberal credit to customers increases working capital needs; credit from suppliers reduces it.

Common mistakes

• Thinking a longer production cycle reduces working capital. It increases it because money stays locked up longer.
• Confusing gross working capital (total current assets) with net working capital.