What are the types of working capital?

3. 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.

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