[Justinnnn]

I am reading through BEC 3 for the second time (and MCQs) and I am struggling with the concept of permanent working capital vs. temporary.

My MCQs practice reveals that.

a. Matching Temporary WC with Current Liabilities reduces risk of technical insolvency (inability to pay)

b. Matching Perm WC with Current Liabilities increases the risk of inability to pay

My issues are as follows:

1. My interpretation of this is temporary WC is accounts receivable or cash/AR. However, permanent working capital is inventory/prepaids/ current deferred tax asset. Permanent working capital is harder to liquidate because:

a. it does not liquidate or

b. in the case of inventory, it is difficult to liquidate large amounts in a short period of time without taking a loss.

a. Is this interpretation correct? Is there a good review material that is pin-pointing this explanation?

b. Is the minimum/compensating balance in a bank considered permanent working capital? Do you have any reference/support for this?

2. My studies revealed that short term debt requires higher temporary working capital levels (consistent with above). What I do not understand completely is the concept that long term debt requires higher permanent working capital levels.

Is this because lenders require a higher level of inventory (lenders may loan up to a percentage of AR or Inventory)?

Is this because a compensating balance is considered permanent working capital (restricted cash concept)?

REG 80 2/7/11
FAR 91 10/8/11
AUD 97 11/22/11
BEC 96 2/4/12

CPA 3/15/13

[GovAuditor89]

Justinnn,

I was struggling with this concept too.

What I gathered is that permanent working capital is basically a MINIMUM level of working capital (inventory, cash levels, etc) that you need to maintain in order to maintain regular operations. This amount will not change regardless of seasonal fluctuations / demand / etc. Temporary working capital is anything ABOVE the permanent WC level which will change from period to period.

The reason you would want to match temporary working capital with current liabilities is because the temporary w/c balance changes from period to period. When the level of working capital is higher you would use the short-term funds, and when the level is lower you would retire them.

Using the same logic, permanent working capital would likely require a more long-term source of financing in order to reduce the risk of fluctuations of price over time, which subsequently reduces the risk of not being able to make obligations.

[Ronny010]

well dear thanks for sharing but i am not aware of this dear 🙂

[Justinnnn]

Thank you for replying, I thought my post was lost in the clouds. Very good points – your explanation reminds me of the Becker example of holding inventory for seasonable demand and also holding inventory year-round.

REG 80 2/7/11
FAR 91 10/8/11
AUD 97 11/22/11
BEC 96 2/4/12

CPA 3/15/13

[Author]

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