A Guide To Permanent Working Capital

If you own an ecommerce business, then you’ve probably heard of the term Permanent Working Capital. Did you have a hard time understanding what it was? Or the difference between permanent and temporary working capital? We’re here to guide you through the world of working capital, so you can plan your budget with ease.

Do you own an ecommerce business? Are you struggling to manage your budget? If so, you may be failing to take an important detail into account. Permanent working capital is a vital piece of knowledge when calculating your budget and is not to be mistaken for net working capital. It’s a consistent and uninterrupted number that keeps your business “alive.” We’ll discuss what that number means for you, the difference between permanent and temporary working capital, types of working capital, and funding options that will help you keep up with that fixed amount. With that said, let’s dive into the world of working capital, so you can return to your budget with confidence.

What Is Permanent Working Capital?

Permanent working capital is the fixed amount of money that covers a business’s short-term expenses. This number isn’t supposed to change often, but it can if your business grows. It can also fluctuate depending on the nature of your operations. If your business grows, then you’re going to have more fixed expenses to cover. This number is vital to the survival of your ecommerce business. Without it, you wouldn’t be able to keep up with the “bare minimum” as it stands. So, this number is the first thing you determine when calculating your budget. Every other expense is determined once the permanent working capital amount is decided. Make sure that you go over your expenses first, though, and calculate whether you can eliminate or reduce them. Less permanent working capital means more cashflow for you.

Examples of permanent working capital expenses include rent, utilities, payroll, and loan payments. If you’re a business that provides services then your accounts receivable can be included in your fixed working capital, especially if they’re on a contractual basis. Customers or clients who operate on a one-time visit or unpredictable schedule shouldn’t be considered a part of your permanent working capital calculations. Other variables that fluctuate are advertising campaigns and inventory. You also need to include your own income in there (everyone needs to get paid).

Types Of Permanent Working Capital

There have been larger-than-life companies that have failed due to a lack of proper budgeting. They chose to borrow loan after loan, instead of reducing unnecessary costs to maintain their permanent working capital. Business is always a gamble, but it doesn’t mean that you can’t be clever about your strategies. First and foremost, pay your bills. If you can’t do this, you won’t survive. If you pool all your funds into a campaign in the hope that it will deliver massive profits…that’s your choice. The vast majority of the time, "slow and steady” wins the race. With that said, let’s discuss the two main permanent working capital types.

1. Regular Working Capital

Regular working capital is the “bare minimum” amount needed for your business to survive. The day-to-day expenses, such as rent, loan payments, payroll, utilities, and other various costs that only you can determine are permanent can be included in this number. It’s a good idea to consider everything that could be “permanent.” That means subscriptions to software, regular supplies, and even work-related streaming services. Little things can add up quickly, and if you don’t include them, they can throw off your carefully calculated budget. So, don’t underestimate your expenses. Always round up your costs—if you don’t feel comfortable calculating an exact amount.

2. Reserve Working Capital

No matter how well you plan out your business operations, a surprise is bound to happen. Your rent could increase, the office could need maintenance, a large outstanding balance could be abandoned, or sales could fall unexpectedly. Reserve working capital is your “emergency fund” for such occurrences. If you take the time to ensure you have backup funds, your cashflow is less likely to be disrupted, which is great for business. You can always replenish during the next sales spike or even with that new client contract. In short, “it’s better to be safe than sorry.”

Types Of Working Capital

It can be difficult to understand the difference between the different types of working capital. There are many variables to each type, meaning there is lots of room for human error. Each business conducts its operations differently, which means that its expenses may not fit into the same category as the next business, even if it’s the same type of expense. It’s up to you to figure out which cost goes into which category, so you can plan a successful budget for your unique business. With these thoughts in mind, we’ve created a list of the working capital types, so you can make an informed decision of your own.

1. Gross Working Capital

Gross working capital, in short, is the amount of capital invested in current assets. This includes everything that gives value to your business. Tangible assets include invoices, property, inventory, stocks, backup funds, office furniture, or company vehicles. All these variables and more can be included in your gross working capital. Most banks and lenders use this number to determine approval and the amount of money to include in the lump sum supplied to you. So, it’s always a good idea to keep records of everything that has to do with your business, no matter how small you think it is. It may make a big difference down the line with banks or private investors.

2. Net Working Capital

This is the “working capital” that most people think of when they come across the term. It’s the number after you subtract your liabilities from your current assets. This figure determines how well your business is doing or the “health” of your company. The goal is to have a positive number after subtracting your current liabilities from your current assets. The figure is meant to fund “non-essential” aspects of the business, such as extra inventory, advertising, and office furniture. The short-term expenses need to be paid if you want to succeed, but their prioritization comes in second compared to permanent working capital.

3. Temporary Working Capital

This number is the one that fluctuates the most. Temporary working capital is net working capital minus permanent working capital. Doesn’t it seem like there’s no end to the subtractions? Be that as it may, a business can generate a lot of revenue if the owner understands the difference between the types of working capital. Temporary working capital is just as important to calculate. This amount changes with the seasons and trends throughout the year. This number is for planning product launches and boosting advertising campaigns. It’s also for preparing for the inevitable slow season, especially if you are a seasonal business.

Regular Working Capital Versus Temporary Working Capital

We covered the basics of regular working capital and temporary working capital, but they are hard definitions to differentiate. So, we’re going to discuss the difference between the two in more depth. Regular working capital, as you know, is the “bare bones” amount of money needed to keep your doors open (whether that be from sales or a loan). Some business owners are happy to keep this number the same, without risking their assets on growing past what they are. For most of us, though, we want to increase our revenue. That means we need more temporary working capital to put toward things that will increase the chances of success.

The temporary working capital fluctuates due to how well your business is doing. If you make more than the bare minimum, this is your “cushion” so to speak. It’s the amount that you need to grow and increase customer returns. For example, perhaps you’re a hair salon with a large clientele. If you’ve booked a few months in advance, you may want to hire a new hairstylist. The employee’s paycheck can quickly become regular working capital, but you can use your temporary working capital to install another station, so they have a place to work. This will increase the number of clients your business sees in one day, meaning your cashflow just grew.

How Do You Calculate Permanent Working Capital?

If you were looking for a formula to work with, then we have bad news—there isn’t one. Every business is different and has various variables that can’t fit into one equation. You’ll need to take a look at the inner financial details of your business to conclude. However, we will provide you with helpful methods to guide you through the process. Remember, every variable counts, so gather all your documents and set aside a few hours to calculate everything. With that said, let’s walk through your numbers and conclude with an accurate permanent working capital.

1. Assess Net Working Capital

Firstly, you need to have your net working capital figure. As referenced above, it can be calculated by subtracting your liabilities from your current assets. With this figure, you can calculate how “healthy” your business is. Anything in the positives is good! From there, you can grow it.

2. Break It Down

To get a better understanding of your costs, you need to break down your net working capital and how it’s used day to day. The small picture is just as important as the big picture. You may see things that can change or can improve for the better. Now, don’t start switching the office’s soft toilet paper with cheap sandpaper. There’s a limit to how far your employee’s loyalty will go.

3. Add Up Fixed Costs

Add up all your fixed costs. These are the things that go into your permanent working capital. The necessary expenses that need to be paid in order for your business to keep its doors open. Seeing this will allow you to eliminate unnecessary expenses and even reduce some that you didn’t see before. Can you refinance your business loan? Maybe you can lower the monthly payments? Things like this make a big difference in the long run.

4. Be Prepared For The Future

As you grow your business, you’ll consequently add more to your permanent working capital. More expenses will pop up, as you decide to climb higher up the ladder. Make sure you have sufficient backup funds to compensate for these projected expenses. You don’t want to rely entirely on loans and credit cards.

What Happens If You Don’t Calculate Your Working Capital?

As we’ve discussed, working capital is a vital piece of an ecommerce business. Without it, you wouldn’t be able to calculate the amount needed for each expense and venture. Credit cards and loans have their place when it comes to growing your business, but they can quickly grow out of control if you don’t have a decent system set up to keep track of your working capital, permanent or otherwise. Spending has to be monitored, especially when there are multiple people involved in the company’s operations. With that said, let’s discuss the possible outcomes of a lack of working capital management.

1. Insufficient Inventory

Inventory is vital to your business, and you need cashflow to keep up with demand. If you don’t keep up with demand, you will lose customers because most people won’t wait for something that’s on “backorder.” They’ll simply go to the next retailer that is stocked with their item. If you spent quite a bit on advertising for a trending item, then the advertising expense would go to waste, too, if you don’t have the money to order more of the goods. Of course, if you provide a service, you may be able to operate on less working capital than the ones who sell goods. Still, we want a positive balance after the math is done, so plan your budget wisely.

2. Low Liquidity

Emergencies and surprise expenses happen. If you don’t have any reserve working capital, then you may be in trouble. When you don’t have enough cash on hand to pay your employees, they may get a bit irritated. If you don’t have enough money to pay rent, then that puts your store or office at risk. Utilities such as electricity and water are vital, even if you’re a business that doesn’t provide services. Your credit card machine won’t work without the internet, and that means fewer customers (no one carries cash on them anymore). Once these things are in question, the rest can quickly fall apart, and it’s hard to catch back up if you can at all. So, in short, plan ahead.

3. Penalties

Penalties start popping up when you are unable to catch up and pay your expenses. Most banks and lenders aren’t forgiving when it comes to missed payments. Penalties can stack up and interest can be increased, which only worsens the situation. Keeping working capital on hand or even locked in a safety deposit box will guarantee a smooth transition through the surprise costs that come with the emergency. The best way to prepare is to review your budget often and make sure that you are staying on track.

4. Bankruptcy

Bankruptcy is the worst-case scenario. This happens when you are unable to pay your debts, so you have to sell your assets to pay them off. No one wants to lose their business due to bad math skills or a “gambling mentality.” Never assume that you’ll grow right away, or even receive profits right away. We only mention this so you can understand how important your budget is. Permanent working capital is a necessary figure to calculate. It’s always better to break-even then fall into the negatives.

What Is Considered A Good Permanent Working Capital Number?

The best way to answer this question is to have you consider your financial and business goals. Since every business has different goals and different numbers, it’s impossible to give an exact amount. Instead, map out your current and future goals for the business, whether that’s improving customer service or expanding to another location. With these answers, you’ll be able to budget according to the expenses you’ll have from these ventures. Do you have one office? Two stores? How many loan payments do you owe? How much will utilities or furniture cost? Do you need supplies for services or goods for sales?

After you answer these questions and come up with your permanent working capital figure, you’ll be able to determine on your own what a “good number” is. If you have “survival mode” in mind, then any positive figure would be a great goal. If you want to expand to another location, then your goal is to grow the net working capital, so you can begin renovations and even the hiring process. So, our response to your question is, “What do you think is a good number for your business?”

In Conclusion

With all this new information at your fingertips, you’re probably ready to return to your budget. Remember that every business is unique, therefore, you should only treat the information you read or hear as a guideline, not as a fact. All the different types of working capital and the many variables that go with each one may be daunting, but once you understand the “bare necessities” that you need to stay open, everything else will fall into place. You can take risks without risking your business, so keep that in mind when you get excited during a campaign or when speaking with an investor. With that said, we wish you luck in your future ventures.