Permanent working capital is the minimum investment required in working capital irrespective of any fluctuation in business activity. Also known as fixed working capital, it is that level of net working capital below which it has never gone on any day in the financial year. Net working capital (NWC) means current assets less current liabilities. This term is important to be calculated for decisions relating financing mix of working capital and save the interest cost of the firm.
NWC = Current Assets – Current Liabilities
NWC = Inventories + Account Receivables + Bank Balance + Cash Balance – Accounts Payables.
For smoothly running the business operating cycle, it is necessary to pay our obligations when due, satisfy the customer as and when a need arises, and improve and promote revenues of the business. For honoring the obligation, we need cash and bank balances as and when required.
For satisfying the customer needs, we need to maintain a minimum level of inventory and to generate revenue and improve customer relations, we have to extend credit and thereby maintain accounts receivables.
Therefore, it is clear from the above explanation, irrespective of the activity levels of the business, a minimum investment in the current asset is always required. This investment requirement is called permanent working capital.
How to Calculate Permanent Working Capital?
There is no formula for calculating the exact permanent working capital. It is an estimation based on the experience of the entrepreneur. Statistical data on the balance of all current assets and liabilities can help in deciding that level. We can plot the net working capital amount of each day in a table and find the lowest amount in it. In the example below, 2500 is the permanent working capital.
Types of Working Capital
Net Working Capital Permanent / Fixed Working Capital Temporary / Variable Working Capital Requirement
|Types of Working Capital|
|Net Working Capital||Permanent / Fixed Working Capital||Temporary / Variable Working Capital Requirement|
Permanent Working Capital is also not Permanent
Permanent or fixed working capital is also not fixed in the long term. As the business grows, it will also grow. We have shown two graphs one for businesses which are set and stable and there is not much change in sales, margin and other workings. Obviously, such businesses are rare. Another graph is for businesses are constantly growing and expanding.
Types of Permanent Working Capital
Since we know that it is impossible to determine the exact amount of permanent working capitaley can also be further divided into following two:
Regular Working Capital
It is the permanent working capital which is normally required in the normal course of business for the working capital cycle to flow smoothly.
Reserve Working Capital
It is the working capital cushion which needs to be maintained over and above regular working capital for contingencies which may arise due to unexpected situations.
Why is Classifying Working Capital as Permanent Working Capital Important?
The prime reason behind differentiating permanent working capital and temporary working capital is the decision relating to the financing mix of financing the working capital gap. After classifying as permanent working capital, we can finance the permanent part of working capital with the long-term sources of finance such equity, debenture, long-term loans etc. Long-term sources are cheaper than the short term sources of finance. This strategy of financing will save the cost of interest for the company.