Temporary working capital (TWC) is the temporary fluctuation of networking capital over and above the permanent working capital. It is the additional working capital requirement arising out of seasonal demand of the product or any special event which otherwise are not predictable. In other words, it is the difference between net working capital and the permanent working capital.
Business earnings are not like the salary earnings of an employee. An employee earns an equal amount of money every month throughout the year. But, businesses are rarely of such nature. In business, businessmen get an opportunity to earn good money at a particular time and all businessmen try to grab such opportunities. This requires additional working capital for him to take that advantage. Such a requirement of working capital is temporary working capital.
How to Calculate Temporary Working Capital?
There is no academic formula for calculating the temporary working capital. If permanent working capital is estimated, TWC can be calculated as below:
Temporary Working Capital = Net Working Capital – Permanent Working Capital.
Data on the balance net working capital can help us calculate temporary working capital. NWC should be plotted for each day and the lowest amount in it is the permanent working capital. In the example below, 2500 is the permanent working capital and besides it indicates the temporary working capital. It is a fluctuating figure.
Types of Working Capital
|Net Working Capital||Permanent / Fixed Working Capital|| |
Temporary / Variable Working Capital Requirement
Temporary Working Capital is also called Fluctuating Working Capital
In the following diagram, we can make out that the temporary working capital fluctuates with the season and with the occurrence of a special event. A stable business should have smaller fluctuations and bigger and growing business would have bigger fluctuations. This is why TWC is also called fluctuating working capital.
Types of Temporary Working Capital
Based on the reasons for fluctuation of the net working capital, the TWC is also is further classified into the following two types.
Seasonal Working Capital
It is that fluctuation of NWC which is caused due to the effect of season. For example, the seasons may be of mangoes, school uniform, audit deadlines, crackers, particular festival, etc.
Special Working Capital
It is the fluctuation in NWC due to some special event which otherwise would not occur. For example, acute summer or winter, floods, famine, a sudden change in government policy, etc.
Why is Classifying Working Capital as Temporary 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. Temporary working capital is preferably financed by short-term financing sources. Even after admitting the fact that long-term sources of finance are cheaper to short-term finances, it is beneficial to adopt the latter because long-term finances cannot be redeemed easily. Short term finances have time flexibility. We can use them and repay them when our purpose is served. A cash credit limit extended by banks is the common way of addressing the TWC. You pay interest on the amount used and for the period of use only. Therefore, in such a situation, idle cash is also utilized to pay off the outstanding of short term finances and save on interest cost.