Classification of Working Capital

Working capital is classified in two different ways — on the basis of concept and on the basis of time. The concept-based classification (gross vs net working capital) was covered in Section 1. This section deals with the time-based classification, which is the one examiners most often ask about.

On the basis of time, working capital is of two types:

1. Permanent (or fixed) working capital. This is the minimum amount of working capital that a firm must keep invested in current assets at all times to carry on its operations, even at the lowest point of business activity. A shop must always keep some minimum stock on the shelves and some minimum cash in the till; a manufacturer must always hold some minimum raw material and finished goods. Because this minimum level never falls to zero as long as the business is a going concern, it behaves almost like a long-term (fixed) investment and is best financed from long-term sources. Permanent working capital is further sub-divided into:

• Regular working capital — the amount needed to keep the operating cycle moving smoothly (minimum stock, minimum cash, minimum receivables).
• Reserve working capital — an extra cushion kept for contingencies such as a strike, a sudden rise in prices, or an unexpected order.

2. Temporary (or variable / fluctuating) working capital. This is the extra working capital required over and above the permanent level to meet seasonal and special needs. A firm selling woollens needs far more stock and cash before winter; a firm selling umbrellas needs more before the monsoon. Because this requirement rises and falls with the level of activity, it is best financed from short-term sources (bank overdraft, short-term loans, trade credit). Temporary working capital is sub-divided into:

• Seasonal working capital — the extra funds needed during the busy season.
• Special working capital — funds needed for a one-off special situation, such as an advertising campaign or an unusually large single order.