What Is Permanent Working Capital?

Introduction

You need working capital to finance your business’ operational needs on a day-to-day basis and meet short-term payments. Yet not all working capital is the same. Different working capitals are available based on the nature and size of a business. The most vital is permanent working capital.

Permanent or fixed working capital is the minimum amount of current assets required to support the everyday operations of your business. It is the working capital permanently invested in current assets such as cash, inventory, accounts receivable and prepaid expenses. Long-term investment in the current assets to support your long-term business needs is permanent working capital.

This article will analyse the concept of working capital in depth. We will also discuss its importance for businesses, measuring it and managing it in the best way possible.

What Is Permanent Working Capital?

Permanent working capital is the least a business requires to keep its operations going for the long term. This part of working capital remains tied up in current assets, cash, inventory and accounts receivable to maintain the proper functioning of the business.

Permanent working capital is also known as fixed or regular working capital. It is the required amount of working capital to maintain a business in operation independent of any sales, production, or demand fluctuations. 

For example, a retail store may need a certain amount of cash, inventory, and accounts receivable to run its business throughout the year, regardless of the seasonal variations in sales or customer preferences. This is the permanent working capital of the retail store. It is the amount of working capital that the store needs to keep on hand at all times to avoid cash flow problems or inventory shortages.

Types of Permanent Working Capital

Permanent working capital can be further divided into two subtypes:

• Regular Working Capital

A business requires minimum working capital to keep cash flow moving and pay for expenses. This working capital is a regular working capital. It is the funds needed in a business to buy materials, make inventory, sell products, receive payments and repeat this cycle. This is a business’s essential productive working capital for survival and effectively performing day-to-day activity.

• Reserve Margin Working Capital

This is the extra working capital that a business reserves for emergencies or contingencies, such as sudden demand spikes, price changes, supply interruption strikes, natural disasters, etc. The reserve working capital is what a business needs to deal with uncertainties and risks.

How To Calculate Permanent Working Capital?

Calculating permanent working capital determines the lowest amount of money your business needs to function smoothly. Here’s how you can do it in simple steps:

1. Determine the Current Assets

Identify assets that can be liquidated within one year or less. The current assets include cash, accounts receivable, inventory and marketable securities.

2. Determine the Current Liabilities

Identify liabilities that are payable within one year or less. The current liabilities may include accounts payable, accrued expenses and short-term loans.

3. Calculate the net working capital

To calculate the net working capital, subtract the current liabilities from the current assets.

4. Determine the permanent working capital

To calculate permanent working capital, add long-term investments (easily liquidated within one year or less) with net working capital. Such investments can be in long-term marketable securities or other assets that can be easily sold off.

By figuring out your permanent working capital, you make sure you always have enough money to keep your business going smoothly. It helps you plan and maintain financial stability.

The Difference between Permanent and Temporary Working Capital

Basis	Permanent Working Capital	Temporary Working Capital
Used For	Funding regular business operations long-term	Funding short-term operations that change with seasons
Time Horizon	Long-term, stable	Short-term, fluctuates
Made Up of	Cash, inventory, accounts receivable	Seasonal extra inventory, short-term loan
Purpose	Effectively carrying on the day-to-day operations	Bridging cash gaps from dips or surprises

Importance of Permanent Working Capital

Permanent working capital has many advantages for your business, let’s discuss them in detail.

Funds Daily Operations and Ensures Liquidity  

Permanent working capital is, first and foremost, essential for paying the ongoing operating expenses of a business as they come due. This includes ordering raw materials, paying employees, covering production costs, and meeting other regular outflows. Having sufficient permanent capital ensures a company avoids disruptive cash shortages that can lead to missed obligations and insolvency risks during inevitable ups and downs.

Supports Business Growth Initiatives

The second essential function of permanent working capital is funding near-term growth plans and expansion projects. These include pursuing new opportunities, product launches, marketing campaigns, facility investments, and acquisitions. Having adequate permanent capital means seizing opportunities at short notice is possible.

Boosts Long Term Profitability and Competitiveness

With the flexibility to consistently fund operations, meet obligations on time, and actualise growth initiatives, permanent working capital enhances profitability and competitiveness over the long run. You can optimise production volumes, operating costs, and sales with sufficient capital cushions. By contrast, chronically undercapitalised businesses struggle with profitability.

Factors that Impact Permanent Working Capital

Multiple factors determine appropriate working capital scales for sustaining business. Let’s discuss them one by one.

Industry Operating Models

Working capital requirements vary across industries based on operating cycles. Trading and retail companies need less due to quicker inventory turnover and consumer cash collection. Conversely, wholesalers and manufacturers require more permanent working capital because production processes and supply chains create longer lags between initial raw material expenditures and final cash receipts.

Business Growth and Expansion

Growth initiatives like entering new geographies, launching products, and expanding facilities require ramping up permanent working capital to fund upfront costs before profits accumulate. High-growth companies need ever-increasing pools of working capital to actualise expansion plans.

Credit Policies for Customers

Another factor is the credit period, or credit terms a company offers clients before payment is due. The longer and more lenient the terms, the higher the working capital required to finance growing account receivables as customers purchase on credit before paying. 

Inflation

Finally, inflation pushes up companies’ input costs like raw materials and wages, which require more working capital to bridge timing gaps between making product expenditures and collecting final payments. With sustained inflation, permanent working capital must rise accordingly.

How to Improve Permanent Working Capital?

Increasing permanent working capital is a blessing for any business as it increases the cash flow and profitability, creating more opportunities to grow and expand. Some ways to improve permanent working capital are:

• Increasing the Sales Revenue
  Sales revenue increase enables you to improve your fixed working capital by capturing market share, developing new products or raising prices. This increases cash flow from sales and supplies more working capital to the business.
• Reducing the Operating Expenses
  By reducing operating expenses, you can increase your permanent working capital by eliminating unnecessary costs, improving efficiency in operations or outsourcing some functions. This leaves more cash from operations for the business, increasing its working capital.
• Negotiating Better Credit Terms
  To negotiate better credit terms is to increase the permanent working capital of a business by lengthening the credit period, lowering the discount or enforcing rigorous collection policy for clients or reducing the credit period, increasing discounts and relaxing payment conditions on its suppliers. This helps you have quicker cash from sales and slower cash payment for purchases, thus increasing the working capital.

Factors to Consider Before Taking Out a Loan for Permanent Working Capital 

For some businesses with a high growth potential rate, stable cash flow, and reasonable credit rating, it may be worth considering to finance permanent working capital. However, before taking out a loan for permanent working capital, you should consider the following factors:

• The interest rate

The interest rate is the price of lending money from a lender. A business should compare the rates on offer from different lenders and opt for the one with a lower rate to minimise interest charges, increasing the net income position of the business.

• The repayment period

The loan repayment period is the number of years a business has to repay money borrowed from an organisation or individual lender. A repayment period should be chosen that corresponds to the life of its current assets; otherwise a business will incur considerable risk as it might mismatch between its liabilities and asset composition.

• The collateral

The collateral is an asset that the business promises to a lender as security for his loan. A business should select a collateral with high value, low depreciation and high liquidity; this move will ensure that the loan for business is approved more easily while reducing the risk of losing an asset in the event of default.

• The covenants

The terms and conditions are put in place by the lender as part of the loan agreement. The business should therefore analyse and fully comprehend the covenants to ensure they are not too restrictionist or unfair, as this would restrict flexibility within its operations.

Conclusion

Any business that intends to operate efficiently and effectively requires permanent working capital as a vital resource. It enables you to be liquid for your current liabilities and daily operations. It refers to the difference between your assets untouched by seasonal or cyclical variances and liabilities. Suppose working capital is permanent and not contingent. In that case, you can manage it by optimising the cash conversion cycle, minimising inventory levels, and improving accounts receivable collection through long-term sources of financing. 

Permanent working capital is not the same as temporary working capital, which refers to a higher level of current assets required to meet peak demand. By differentiating permanent and temporary working capital, you will also better your liquidity solvency. If you need working capital loans to manage your working capital, you can reach FlexiLoans. We offer hassle-free business loan approvals; here, you can get a loan sanctioned quickly.