Classification of Working Capital. Working capital may be classified in two ways, viz., on the basis of “concept” or on the basis of “time,” both of which are discussed below:
1) On the Basis of Concept:
On a conceptual basis, working capital is classified as ‘Gross Working Capital’ and ‘Net Working Capital. For the department of Financial Management of a company, this classification is of paramount importance.
i) Gross Working Capital:
The amount which a company has invested into its current assets is referred to as the Gross Working Capital. Generally, working capital is viewed as Gross Working Capital.
ii) Net Working Capital:
The difference between the current assets and current liabilities of a company is referred to as the “net working capital.”
2) On the Basis of Time:
On the basis of time. working capital may be classified into:
i) Permanent/Fixed Working Capital, and
ii) Variable Working Capital.
1. Permanent Working Capital :
The minimum level of ‘Working Capital’ required by a company to manage its operations is referred to as Permanent Working Capital. It is also termed Fixed Working Capital. Its level is not dependent on the production or sales of products. Due to its nature of permanence, it is similar to fixed assets, although over a long period of time its level is variable. It differs from one industry to another and from one company to another and depends upon the factors like business cycle and the pace of growth.
Permanent working capital may be further sub-classified into two categories:
1) Regular Working Capital:
2) Reserve Working Capital:
Permanent Working Capital, which is in excess of Regular Working Capital, is termed ‘Reserve Working Capital’. It originates from emergencies like economic slowdown, labor problems, etc.
2) Variable Working Capital
A uniform level of ‘Current Assets’ is not required to be maintained throughout the year by a manufacturing unit. Generally, the demand for a product is cyclic or seasonal and on the basis of demand, the year may be divided into two seasons, viz. peak season and slack season. During the peak season (Deepawali, Christmas, Id, and other festivals), retailers need to maintain a high level of inventory because of the increase in demand by consumers. As a result, the manufacturer’s investment in inventories RMS, WIPs, FGs) needs to be more.
On the other hand, during the slack season, investment in inventories (RMS, WIPS, FGs) needs to be reduced by the manufacturers in tune with the reduction in demand.
The level of demand for a product is not uniform throughout the year and as a result the level of production and sales also fluctuates, and so does the level of Current Assets’ requirement. The working capital requirement in excess of ‘Permanent Working Capital’ is what may be termed as ‘Temporary Working Capital’, ‘Variable Working Capital’, ‘Fluctuating Working Capital’, or ‘Cyclical Working Capital’.
Temporary working capital may be further sub-classified into two categories:
1) Seasonal Working Capital:
Temporary working capital requirement for meeting the normal seasonal demands.
2) Special Working Capital:
Temporary working capital requirement for meeting demand caused by special occasions, e.g. for the advertisement of the manufacturer’s product, special working capital is required.
The sources of financing the ‘Fluctuating Working Capital’ differ from that of ‘Permanent Working Capital’, due to its cyclical nature. Financing of Permanent Working Capital’ is generally done through long-term sources, like equity or debt, whereas financing of “Temporary Working Capital’ is generally done through short-term sources.
Costs Associated with Inventory- Click here