What is Fixed Capital?
- Fixed capital refers to permanent investments and is often parallel to fixed assets in an entity. Fixed assets are an application of the fixed capital obtained from various resources.
- If you observe any balance sheet, there are sources of fixed capital such as equity, debt, borrowings, and debentures on the liabilities side. So, this money goes into financing or purchasing the fixed assets, as visible on the assets side of the balance sheet.
- The objective of holding any fixed asset is to earn revenue out of its usage. Thus, the fixed assets are not intended for sale in the ordinary course of business. Instead, they form the basis for the smooth administration of the company. Accordingly, their absence would paralyze the operations of the entity.
- Thus, fixed capital is permanent, and the related fixed assets are used in the company’s production process. The finance is locked for a substantial period until the business continues. It is generally withdrawn only if the entity’s company is winding up.
Key Takeaways for Fixed Capital
- It refers to those investments which are fixed in nature and are often parallel to fixed assets in an entity. Fixed assets are nothing application of the fixed capital obtained from various resources.
- The objective of holding any fixed asset is to earn revenue out of its usage. Accordingly, fixed assets are not intended for sale in the ordinary course of business. The classic examples of this include tangible assets, intangible assets, and non-current assets.
- Its sources include the issues of equity shares, debentures or rights issues, term loans, lease financing, and retained earnings.
- It is generally less liquid since the assets have been ultimately used during their useful life.
- The decisions taken for fixed capital are critical since they are irreversible unless a high cost is incurred.
Example of Fixed Capital
If you look at the asset side, fixed capital is used to finance an entity’s fixed and non-current assets. Classic examples of fixed capital are:
- Tangible assets such as land, building, plant and machinery, and fixed equipment are held as a foundation for any machinery, furniture, fixtures, vehicles, or office equipment.
- Financial non-current assets such as advances given to subsidiary entities or affiliate companies, prepaid expenses,
- Intangible assets such as Goodwill of the business, copyrights, patents, and trademarks.
- It refers to money blocked due to long outstanding receivables, inventories, and vendor advances.
If you look at the examples from the liabilities side, these are covered as sources of fixed capital in the next heading.
Sources of Fixed Capital
Different sources are mentioned below:
1. Equity Capital
It is the first source of fixed capital. This refers to the financial resources arranged by the owners. In the case of companies, the shareholders are the ones who contribute to the issue of equity capital. Funds from these investors are then used to finance a project or a new venture. Financial bankers have criteria for minimum infusion of the owner’s capital before applying for a bank loan.
2. Term loan from a financial institution
The secondary source of fixed capital is a bank or financial institution. Bankers provide the loan after understanding the business model and the expected cash flows from the said business. Depending on the loan size, bankers may or may not ask for a mortgage or security against such a loan. The finance cost, i.e., the interest rate on loan, depends on the periodicity of the loan and the business risk. Since the funds are to be used for financing the fixed assets of an entity, the periodicity is generally more prolonged, and thus the interest rate is usually lower.
3. Listing of shares/IPO/FPO
Companies that fulfill the basic checks of the regulatory authority can apply for an IPO (Initial Public Offer). Private companies may go for the launch of IPO to fund their capital needs. The finance in the form of equity infusion is also treated as fixed capital. An existing listed entity may apply for a further public offer (FPO) for such a purpose. IPO / FPO will dilute the equity holdings from promoters to the public.
4. Financing through retained earnings
If the company is cash-rich, the finances can be arranged through retained earnings. Retained earnings refer to a part of the post-tax profits that the company has accumulated over the years.
5. Through debentures
This is another method of funding the assets. Here, the company issues bonds to the investors. The prospectus should specify the expected utilization of the funds to be procured. For the debentures, the investors receive coupon amounts. Since the usage of the funds is for long-term resources, the term of the bonds is higher.
6. Issue of right shares
Right issue of shares refers to an invitation to the equity shareholders of an entity to purchase additional equity shares of the company at a specific date in the future. Such an offer discounts the current market price and can be made only to existing shareholders. Proceeds from such an issue can also be used to fund the fixed capital of the company.
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7. Lease financing
It refers to another long-term source where the asset owner leases the fixed asset or any principal machinery to another person. The lease period is substantial enough to cover the valuable life of the investment. Hence, even if the nature of expense is a lease, it is treated as a source of fixed capital.
Incremental Fixed Capital
- It refers to the additional capital infused by the investors either to maintain existing fixed assets or to fund the addition of assets. Such additions are necessary to increase the capacity of the plant. An increase in plant capacity is required to cope with the increased demand for the products.
- The sources of such incremental fixed capital can be the same as we discussed for the source of fixed capital. The cost of such finance depends based on finance. The funding cost is generally lower if the sources of such finance are through outsiders (such as term loans, debentures, etc.).
- If the company cannot achieve the target turnover in the future, such incremental fixed capital may dilute the fixed assets turnover ratio. In case of reduction of such ratio, the operating efficiency is also reduced.
Liquidity
- Liquidity means how quickly you can sell off an asset and realize the proceeds. As a result, permanent capital suffers from lower liquidity.
- It is generally less liquid since the assets have been ultimately used during their useful life. Also, fixed assets can be customized for a specific entity, and another company may not find it helpful.
- It may take months or years to sell a fixed asset; thus, money may be blocked until the actual realization of the proceeds. This is one of the primary reasons companies have to suffer a long liquidation period.
Importance
- It plays a vital role in the foundation of any business entity. It helps in establishing the operating units.
- Since a substantial portion of funds is blocked in fixed capital, the investments are well-planned enough. Also, a detailed analysis is carried out to check the sufficiency of the expected stream of cash flows. One of the crucial decisions is the source of fixed capital and the relevant finance cost.
- The decisions taken for this are critical since they are irreversible unless a high cost is incurred.
- Its decisions have a long-term bearing on the growth of the entity. The gestation period for realizing the returns is usually longer.
- It influences the overall viability of the project wherein the fixed assets are to be used.
Conclusion
The fixed capital generally gets recovered within 7-8 years. However, depreciated fixed assets have lower operating efficiency. Hence, the company may need to reinfuse fixed capital to consider replacing old machinery over time.
Recommended Articles
This is a guide to Fixed Capital. Here we also discuss the definition, example, souces, Incremental, and Liquidity of Fixed Capital, along with the importance. You may also have a look at the following articles to learn more –
