Understanding Operating Capital (+Examples)
THE COMPLETE GUIDE TO UNDERSTANDING OPERATING CAPITAL
Does your business have enough cash flow to overcome cash crunch worries? Most businesses fail, simply because they don’t have enough cash flows.
While productivity and efficiency are both important, there is nothing like falling behind in terms of cash flows, and something that you would want to avoid.
Capital is an important resource in a business setting and enables the firm to continue its operations. Capital can include physical items like raw materials, equipment, plants as well as human resource capital.
Anyone with even the slightest idea of how businesses work knows the importance of capital in running an organization.
The PWC’s 2018-19 Working Capital Report, for instance, talks about how businesses are finding it harder to convert cash, and how the working capital has only improved minutely for many businesses.
Another report, by FTI Consulting, talks about how Australian businesses have seen their working capital decline by as much as 4% in the last five years.
Today, we will explore a category of capital that businesses need to meet their daily expenses and maintain their operations.
It is called operating capital, and this post will attempt to make you aware of the implications of operating capital.
WHAT IS OPERATING CAPITAL?
Operating capital is the capital required by a business to run its daily operations.
Also known as working capital, it includes the available raw materials and financial resources.
All of the resources together is called the operating capital.
Operating capital represents the ability of a company to meet its production targets and other short-term obligations.
If a company fails to generate adequate operating capital, then the business operations will be affected negatively.
For this reason, you can use operating capital to gauge the short-term financial health and operating efficiency of an organization.
For example, consider a company which manufactures sports shoes.
To continue its production, you need the company to purchase raw materials like rubber, plastic, fabric by paying cash.
After the company sources the raw materials, it will need the workers to operate the machines to produce the finished goods.
So the company also needs to pay for electricity, oils, lubricants, water, and other resources required for production.
The sum of all the expenses above will represent the operating capital of the firm.
Did you understand the concept clearly? If not, we are going to make it more simple for you to understand-
You can relate to operating capital as your individual cost of living to make it easy to understand. You will need to collect money that people owe you and keep a certain amount daily to pay for bills and cover other regular and day-to-day expenses. Operating capital acts in the same way to cover the expenditures a business makes daily.
Now that you have an idea what operating capital is, let us see how you can find out the operating capital of a business.
HOW TO CALCULATE OPERATING CAPITAL?
You don’t need to be an accounting ‘Guru’ to find out the operating capital of a business.
Operating capital can be found out using a simple method.
You have to find the difference between the current assets and the current liabilities to get your operating capital. Therefore-
Operating capital = current assets – current liabilities
Examples of current assets include cash, inventory, marketable securities, accounts receivable, prepaid expenses, short-term advances and so on.
Current liabilities include items such as paying taxes, short-term debt, accounts payable, accrued expenses, the current percentage of long-term debt and deferred revenue.
Current assets include those assets which the company can convert to cash in a year. In the same way, current liabilities are those liabilities which are payable during the current financial year.
Let’s take an example to find out operating capital.
ABC company finds out that its total current assets sum up to $1,500,000. The total of all current liabilities comes to $1,000,000. So how do you calculate the operating capital?
We know that operating capital is the difference between current assets and current liabilities. So,
Operating capital of ABC company is $1,500,000 – $1,000,000 = $500,000.
It means that ABC company has an operating capital of $500,000 to pay for its operating expenses.
Availability of operating capital doesn’t necessarily indicate its adequacy or inadequacy to meet operational expenses.
Sometimes, a company can also have negative operating capital.
This happens when the current liabilities are more than the current assets.
For example, let’s say ABC company has current assets worth $1,500,000 while current liabilities amount to $2,000,000. Then the operating capital is-
$1,500,000 – $2,000,000 = -$500,000.
You can see that ABC company has a negative operating capital which is certainly a red flag for the company. It means that the company won’t be able to meet its operational expenses.
In that case, it may need to raise additional capital by borrowing money or selling off some of its stocks.
Companies also take help of ratios to evaluate their operating capital. We will find out more in the next section.
IMPORTANT WORKING CAPITAL FORMULAS
Here is a look at some of the important working capital formulas you need to know about.
This is a simple ratio that will determine how many times a company can pay off its current liabilities with its current assets.
There is not too much use for this ratio outside of a set context, but if the value is greater than 1 then it shows that the company is more liquid and has assets that can be converted into liquid cash soon.
This ratio is measured by dividing the current assets from current liabilities.
|Current Ratio = Current Assets/Current Liabilities|
Current Ratio = $40,000/$20,000 = 2
This means that the company can pay off its current liabilities two times over using its current assets.
This ratio is mostly used as a general understanding of how the company is doing in the short term.
This ratio is quite similar to the current asset ratio, but in comparison, it separates only those assets that are the most liquid (Debtors and Cash in Hand).
The reason for this is to measure the liquidity to a better standard.
In the current ratio, all forms of liquid assets were used to measure current assets including inventory, which is not always the most beneficial asset to liquidate for spot cash.
It is also not very easy to liquidate the existing stock to gain a high benefit from it.
For that reason, the quick ratio eliminates this aspect of the current assets and then measures the liquidity.
|Quick Ratio – (Cash, Debtors and other securities)/Current Liabilities|
Assets = Cash – $5,000. Inventory – $10,000. Debtors – $10,000
Liabilities = Creditors – $5,000. Loan – $5,000
Quick Ratio = $15000/$10,000 = 1.5
The current ratio value would have been 2.5 if used in the above example, but there is a significant reduction in the value with the inventory being taken away.
This gives a more realistic idea of what the financial situation would be like in the time of an emergency when urgent cash would be needed.
Inventory Turnover Ratio
This ratio is used to measure how many times Inventory turns over (sold and replaced) in the business within a period of time.
This will give the business an idea of how fast they can convert their stocks into cash.
The ratio is calculated as follows:
Inventory Turnover = Cost of Goods Sold/Average Inventory
The cost of goods sold value can be found on the income statement of any business.
Average inventory is calculated by adding the starting inventory to the closing inventory and then dividing it by two.
Cost of Goods Sold = $20,000
Opening Inventory = $7,000
Closing Inventory = $5,000
Average Inventory = ($7,000 + $5,000)/2 = $6,000
Inventory Turnover = $20,000/$6,000 = 3.3 times
A higher value above the industry standard will show that the business is effective in manufacturing their stocks and selling it off to make cash within a period of time.
A higher turnover rate would mean that the business has a healthy working capital value.
Average Age of Debtors
If the business has a lot of credit sales where they sell their products off to their customers on a credit basis, then this ratio will be quite useful for them.
This will identify the average amount of time it will take a business to collect payments from their debtors and thus how fast the cash flows within the business. The ratio is calculated as follows:
|Average Age of Debtors = Accounts Receivable/Annual Credit Sales * 365 Days|
Debtor Days = $250,000/$2,000,000 = 0.125 * 365 days = 46 Days
Typically, if the average number of days is below 60, then the business should be doing okay as per the industry standard.
But, the lower the business can make this, the faster they can get cash into the business, pay off their bills and ultimately have good working capital levels.
THE OPERATING CAPITAL RATIO
Apart from using the above formula, you can also analyze working capital using the operating capital ratio based on your company’s current assets and liabilities.
All that you have to do is to divide your current assets by current liabilities to find out the operating capital ratio-
Operating capital ratio = current assets / current liabilities
Let’s say the current assets of ABC company is $1,500,000 while current liabilities equal to $1,000,000. Therefore, the operating capital ratio is-
Operating capital ratio = $1,500,000 / $1,000,000 or, 1.5.
The operating capital ratio can be used to find out the liquidity of your company. Liquidity represents the ease of converting your current assets for cash and sometimes used by investors to determine the financial position of a company.
An operating capital ratio equal to or greater than one means that the company is more liquid and hold liquid assets which can be converted into cash to meet the operational expenses and liabilities.
If your operating capital ratio is less than 1, it means that your amount of liabilities are more than your assets and you have negative working capital.
Consequently, your company can face financial difficulties and even become bankrupt in the worst case scenario.
For instance, let’s say ABC company has current assets worth $1,500,000 and current liabilities are worth $2,000,000. So operating capital ratio is-
Operating capital ratio = $1,500,000 / $2,000,000 or, 0.75.
The ratio is less than 1 and indicates that ABC company is not in a very stable financial condition.
You should also remember that a high operating capital ratio doesn’t always indicate a favorable financial position.
It can also mean that you have a surplus of inventory or additional assets which you are not investing in the company.
So what should be an ideal operating capital ratio?
The answer varies from industry to industry, and an operating capital ratio of 1.2 to 2.0 is considered the optimum range.
Another way to determine the liquidity of your business is to find out the quick ratio which can indicate your short term liquidity.
The formula only considers most liquid assets like receivables and cash to find out liquidity. Using the quick ratio makes sense when you don’t want to liquidate your inventory or other non-current assets and calculated as-
Quick ratio = accounts receivables, marketable securities and cash / current liabilities
Operating capital is an important aspect and businesses need to ensure they have enough of it to run its operations. We will now take a look at the importance of operating capital.
THE IMPORTANCE OF OPERATING CAPITAL FOR A BUSINESS
Operating capital or working capital is a necessity for all businesses.
You will need a regular amount of cash to purchase raw materials for the production of goods, make routine payments and cover other unexpected costs.
Operating capital is also an important metric to gauge the liquidity, efficiency and the overall financial health of your company.
The capital reflects the outcomes of different business activities such as inventory management, revenue collection, payments to suppliers and debt management.
The measure also ropes in accounts payable, inventory, cash, accounts receivable, amount of debt due and other short-term accounts.
Operating capital also has other important aspects for your business such as –
1. Ensuring Production Activities
You can ensure a smooth production process only when you have adequate operating capital in your hands. There should be adequate accounts receivables, inventory and cash to support your on-going production process and make up for outstanding debt obligations.
You can also replenish your inventory and allow credit sales without hampering your financial position when you have adequate operating capital.
2. Avail Financial Support or Loans
We have discussed how you can use the operating capital ratio to find out the liquidity of a company.
Investors and other interested parties will rely on the operating capital or the operating capital ratio to evaluate your company and its performance.
They will be able to make out if your business is financially healthy and being managed efficiently as operating capital is a good indicator of the status of your accounts receivable, accounts payable, inventory and cash.
If you have a favorable operating capital, then it will be easy for you to convince investors or lenders to get loans or financial support.
3. Make Up for Sales Fluctuations
You can stay afloat in fluctuating market conditions by relying on your operating capital.
This aspect is more crucial if you are operating in a seasonal industry, as the operating capital ensures the continuity of production even during the low seasons.
If you have adequate operating capital, you can bridge the revenue gap resulting out of sales decline in offseasons.
Otherwise, you are more likely to default your bills and other short-term debts which will impact the credit profile of your business.
4. Helps to Grow Your Business
Having sufficient operating capital gives you more flexibility and satisfy the demands of your customers. You can also use the capital to expand your business and exploit new opportunities.
The money can be used to invest in new products or services or to enter a new market. The operating capital can act as a cushion when your business needs a bit of extra cash for varied reasons.
We are sure now you have realized the importance of operating capital for your business. But do you know it is also essential to manage operating capital effectively?
Let’s take a look at the reasons so that you are not left in the dark!
THE IMPORTANCE OF OPERATING CAPITAL MANAGEMENT
If you own a company, then you need to manage your operating capital properly. In case you fail to have adequate capital, then your business will not be able to cover its obligations.
You can also encounter financial insolvency and more likely to run into legal troubles and liquidation of assets.
Finally, you may have no choice other than filing for bankruptcy! Surely you don’t want that to happen!
You have to follow a sound accounting strategy to manage your operating capital.
The strategy should ensure that you have sufficient funds between your current assets and current liabilities.
With a sound operating capital management strategy, you can meet all your financial obligations and even have the opportunity to boost your earnings!
You will need to manage various aspects of your business to manage operating capital effectively.
This will include managing cash, inventories, accounts payable, accounts receivable and other related accounts.
You can use different key performance ratios to identify the aspects of your business you need to focus on for ensuring profitability and liquidity.
Such metrics include collection ratio, operating capital ratio and inventory turnover ratio.
You should always monitor the liquidity position of your business because it directly represents your company’s credit image.
In the next section, we will discuss a few steps you can use to optimize your operating capital.
HOW TO OPTIMIZE OPERATING CAPITAL?
1. Try to Reduce Inventory
You need to analyze your production planning and orders to find the means to reduce your inventory. Some steps to reduce inventory include-
- Accurate demand forecasting
- Eliminating non-value adding steps in the production process
- Making production process simpler through standardization of products
2. Faster Payment Collection
You can increase your operating capital by paying early and collecting payments late.
The cash flow can be increased by-
- Promptly issuing invoices
- Sending payment reminders and cutting back on grace periods
- Revising payment terms and conditions to enable quicker payments
3. Increasing Payable Timeline
You can negotiate with your suppliers to lengthen your payables cycles and enjoy favorable terms.
Also, wait till the due date to make your payments after the supplier has fulfilled all his obligations.
You can also achieve positive cash flow by balancing account receivables and payables.
4. Establish Measurement Metrics
You can optimize your operating capital by developing an effective program and communicating it with all stakeholders in your organization.
Establishing measurement metrics will help you gauge the fulfillment of goals and act as a feedback mechanism.
You can also rely on analytics to optimize operating capital in your organization.
Now we will consider a case study to help you give a clear picture of how firms manage their operating capital.
CASE STUDY: OPERATING CAPITAL MANAGEMENT BY A PHARMACEUTICAL COMPANY
A pharmaceutical company was looking to reduce its operating capital footprint and sought the consultation of Bank of America Merrill Lynch.
Following strategic operating capital management, the pharmaceutical company was able to reduce its operating capital footprint by $2 billion.
The company focused on multiple aspects to achieve its target.
The first step the company took is to go through its trade receivables account to identify potential opportunities to control the credit terms.
The organization also focused on accounts receivables to deal with slow payments and appointed a third party who could take the risks of collecting dues by discounting the invoices.
The company was able to slow down the consumption of operating capital by adjusting the payable obligations.
It followed the present payment terms and even made the payments before due date which directly impacted their operational efficiency.
The inventory of the company also went through an overhaul, starting from basic inputs to the finished products.
The company wanted to achieve the optimal level of inventory as cash is tied up with maintaining inventory.
The firm was able to free up cash by reducing inventory and add the cash to its operating capital.
Another important step in managing operating capital was to create an operating capital scorecard and dashboard.
The step ensured that both the managers and the corporate team have greater visibility and increase their focus on operating capital management.
The managers were also given an operating capital optimization tool kit to fall back upon whenever required.
The success of managing operating capital depended mainly on three aspects-
- Creating a cross-functional and sustainable enterprise approach that focused on key elements
- Optimum utilization of available resources, tools, processes, data and technology
- Empowering a person with accountability, authority and executive support to deliver results
You can use the case study as a blueprint to optimize operating capital in your business and boost your profitability.
Operating capital is required by businesses to run the production process and meet other daily expenses.
The amount of operating capital needed varies from industry to industry and company to company so no standard amount can be quoted.
As a business owner, it is your responsibility to strike the perfect balance between your current assets and liabilities so that you can have adequate operating capital to carry out your business operations and meet other financial obligations.