Types of working capital

There are two types of working capital: permanent working capital and temporary working capital. In this article you will learn the difference between the two and how each of them can be financed (funded).

1. Definition of working capital

Working capital is the difference between current assets and current liabilities.

When we say working capital, we are referring to the net working capital. Firm’s investment in current assets is called gross working capital. The different between current assets and current liabilities is called net working capital. Net working capital can be positive or negative. When current assets are in excess of current liabilities, net working capital is positive. On the other hand, when current liabilities exceed current assets, net working capital is negative.

Gross working capital indicates firm’s investment and financing of current assets. Net working capital, on the other hand, shows the liquidity of a firm. As the result, net working capital indicates the financing needs of a firm, both through long-term and short-term financing sources.

Working capital is the part of firm’s capital that is used for routine day-to-day business operations. In other words, working capital refers to the funds needed by the business to run its operations for one accounting year. Working capital reflects the amount of money a firm has at its immediate disposal.

Adequate working capital is important for any business operations. Working capital financing, however, can be a challenge for a business, especially for a small firm. In order to understand the best way to finance working capital, it is important to understand the difference between the two types of working capital:

permanent working capital
temporary working capital

2. Permanent working capital

Permanent working capital is the minimum level of current assets required by a firm to carry-on its business operations.

Essentially, permanent working capital is the minimum level of working capital required for a firm to operate.

Permanent working capital is also called fixed working capital. Permanent working capital does not depend on the level of production or sales. It is similar – in some sense – to fixed assets because of its permanent (fixed) nature. Important to note, however, that permanent working capital is not literally fixed: its level can change over time. The level of permanent working capital depends on the business cycle as well as the growth of a firm.

Permanent working capital can be further divided into the following categories:

Regular working capital: minimum level of working capital required to circulate from one form to another: from cash to inventory, inventory to receivables, receivables to cash, and so on.
Reserve working capital: permanent working capital in excess of regular working capital. Reserve working capital arises from such contingencies as union strikes, recession, etc.

Temporary working capital

A business does not need the same level of current assets throughout the year. For example, during a slack time a manufacturing company does not need to invest as much into raw materials, work-in-process, or finished goods inventory because of the decrease in sales. On the other hand, during a peak season (e.g., Thanksgiving and Christmas holiday season), retail stores need higher levels of merchandise. As we can see, during the year the level of production and sales fluctuates, and thus, the need for current assets also fluctuates. The need for working capital in excess of permanent working capital results in temporary working capital.

Temporary working capital is the excess of working capital over the permanent working capital.

Temporary working capital is also called variable, fluctuating, or cyclical working capital. Temporary working capital can be further dived into the following categories:

Seasonal working capital: temporary working capital required to meet seasonal demands
Special working capital: temporary working capital required to meet special demands

Temporary working capital differs from permanent working capital because of its cyclicality. As the result, temporary working capital usually requires a different source of financing than permanent working capital. While permanent working capital is usually financed through a long-term financing source such as equity capital and debt, temporary working capital is often financed by short-term funds.

Long-term sources of finance may include (not an exhaustive list):

Equity capital
Debentures
Long-term loans
Retained earnings

Short-term sources of finance may include (not an exhaustive list):

Bank credit
Trade credit
Commercial paper
Factoring
Bills of exchange
Sale or lease of fixed assets

Financing sources can further be divided into the following categories: long-term (5+ years), medium-term (1-5 years), and short-term (<1 year). Medium-term and short-term sources of finance are used to meet the immediate need for cash as well as the need for temporary working capital.

Sources of finance can be used jointly. Most firms use external and internal sources of finance that are both long-term, medium-term, and short-term in nature.