What are the 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. For more information about working capital refer to tutorial Liquidity and working capital analysis.
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.
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