Fixed vs. working capital: how are they different?

Money is fungible. If you borrow a dollar from a friend, it doesn't matter if you give your friend back the exact same dollar or a different one - both bills have the same value. But in business financing and accounting, separating and categorizing funds can help you better understand your business's financial situation and plan for the future. Fixed capital and working capital are two such categories.

What is fixed capital?

Fixed capital describes the long-term funds and tangible assets owned by a business. Generally, these are resources that will serve the business for longer than the following 12-month period.

A business's fixed assets could include a major piece of equipment, a building, or a multi-year lease. These assets are what is known as fixed capital because, although the business may use them to create its products or services, the assets aren't used up during production.

On a balance sheet, you may see a business's fixed assets broken down into different categories, such as: furniture, machinery, equipment, vehicles, land, and buildings. Sometimes, several of these are combined into a category for property, plant, and equipment, or PP&E.

Whether you're starting a new business or planning an expansion, knowing the fixed vs. working capital requirements will be important. For example, if you want to open a mechanic's shop, you'll likely need to invest in expensive pieces of diagnostic equipment, car lifts, and other types of machinery. By contrast, you may be able to start a consulting business with a small investment in an office space and computer - a much smaller fixed capital requirement.

What is working capital?

Working capital is the money that your business has available in the short term, which is generally defined as the following 12 months. You'll use these funds to pay for day-to-day expenses, such as payroll, supplies, and maintenance. Even if you have lots of fixed capital and long-term assets, one of the differences between working capital and fixed capital is that positive cash flow and sufficient working capital are essential to keeping your business running.  

Calculating new working capital

You can determine how much working capital a business has at any given point by adding up the business's current assets and subtracting its current liabilities. The result is also referred to as the business's net working capital.

Net working capital = current assets - current liabilities

• Current assets can include cash, accounts receivable, office supplies, prepaid expenses (such as a prepaid insurance premium), and inventory that you expect to sell within the next 12 months.
• Current liabilities are the expenses that the business must pay within the next 12 months. These could include your accounts payable, employees' wages, and taxes. If you've borrowed money, the amount that needs to be repaid in the next 12 months is also part of current liabilities.

Both the current assets and liabilities are found on a business's balance sheet, which you may be able to create using your accounting software - or get a copy of from your accountant.

What is a working capital ratio?

Additionally, you can use your current assets and liabilities to determine your working capital ratio.

Working capital ratio = current assets / current liabilities

For example, a business with $100,000 in current assets and $80,000 in current liabilities has $20,000 of working capital ($100,000 - $80,000) and a working capital ratio of 1.25 ($100,000 / $80,000).

A working capital ratio of one indicates the business has just enough assets to cover its liabilities, but not much wiggle room. Negative working capital and a negative working capital ratio is a warning sign that the business might not be able to cover its short-term financial obligations.

A ratio above one is a positive sign as it tells you the business has more than enough assets to cover its short-term liabilities.

However, having too much working capital isn't always good - it may indicate you're not efficiently using your cash. Unless you're intentionally saving up for a large purchase or an upcoming slow season, you might want to look for ways to invest some of the money in your business's growth.

The difference between working capital and fixed capital

Working capital and fixed capital are both important to a business's success, but they're different in several ways:

• The time frame. Working capital refers to short-term assets and liabilities while fixed capital is all about the big picture. Sometimes the difference between working capital and fixed capital isn't strict, though, and there's overlap, though. For example, if you take out a business loan, you'll include the short-term debt payments in your current liabilities when calculating your working capital.
• The purpose of fixed vs. working capital. Working capital ties in with the business's operations and cash flow - you'll need these funds to run your business. A capital investment in a fixed asset may immediately start helping the business, but it's intended to have a larger and longer overall impact. You could think of working capital as tactical funds while fixed capital is more strategic.  
• Liquidity. Working capital includes liquid assets, meaning things of value that you can quickly sell and convert into cash. Your business's inventory is a good example, as you may expect to sell your current inventory and replace it with new stock every few weeks or months. However, the difference between working capital and fixed capital in terms of liquidity is that you might be able to sell a fixed asset, such as a company car or building, on short notice. You might not get a fair price if you're forced to quickly sell large assets. Additionally, no matter your time frame, it can be difficult to sell some forms of fixed capital, such as a loan, lease, or intellectual property.

Balancing fixed capital and working capital

Fixed capital and working capital tie into your long-term vision for your business and the short-term realities of running the business.

With the long-term in mind, look for opportunities to invest in fixed capital assets that will benefit the business for years to come and align with your plans for expansion or growth. However, while fixed capital investments can increase your business's book value, also consider how the investment will impact your working capital. Instead of looking at it as fixed vs. working capital, think more about how the two work together to form the foundation of your success and help your business continue to grow.

In spite of long-term profitability and a high book value, many businesses fail because they don't have enough money to cover payroll or pay suppliers. If you haven't already fallen behind on bills, a negative working capital ratio could be an early warning sign that you'll run into trouble soon.