Operating working capital (OWC) refers to a company’s current assets used in its day-to-day operations. It’s a financial metric to gauge a company’s liquidity. It also indicates whether a company can cover its short-term obligations.
When a company’s working capital is high, it may mean all or most of its capital is tied up in day-to-day operations. In this instance, a company would need more capital if it wants to expand its operations to offer more products.
In business, there’s a lot of talk about a company’s cash flow because it’s critical in growing a successful company. For instance, a business with readily available cash can jump at profitable opportunities when they arise. But a company strapped for cash limits the company’s ability to take advantage of opportunities or take chances on innovative ideas.
This article explains what OWC is used for, how to calculate it, and how working capital loans work.
How Is Operating Working Capital Used?
Operating working capital means a business’s capital is already tied up in its operations. Operating expenses include employee salaries and wages, raw materials and supplies, inventory, utilities, and rent.
Positive working capital shows how efficiently a company uses and manages its funds. It reveals how much cash a business has and is a measure of liquidity.
When a business has negative working capital, it may mean that it has exhausted its capital to fund its operating cycle. If the company wants to expand its operations, such as buying new equipment or renting a bigger space to meet the demand of peak seasons, it will need more funding.
Understanding how working capital works is critical, as it affects many aspects of your business. Working capital keeps your company operating smoothly to meet its financial obligations and provides you with the cash flow flexibility necessary for growth.
The Formula for Operating Working Capital
The operating working capital formula is:
Operating Working Capital = Current Operating Assets – Current Operating Liabilities
Cash and cash equivalents are typically excluded from operating current assets. Any short-term debt or long-term debt that incurs interest is also normally excluded from operating current liabilities.
As the name suggests, operating working capital strictly measures assets used for a company’s operations (e.g., inventory, equipment, and wages). Cash becomes a part of the operating working capital financial ratio once it is used to buy materials and supplies.
The working capital ratio is calculated by dividing total current assets by total current liabilities. This quick ratio can also be called the current ratio.
An Operating Working Capital Example
Here’s an example of the working capital calculation that can be used as a template for your own business.
In a typical balance sheet or financial statement, you’d find these assets and liabilities:
| Assets | |
|---|---|
| Cash | $12,000 |
| Marketable Securities | $33,000 |
| Accounts Receivable | $17,000 |
| Inventory | $44,000 |
| Prepaid Rent | $9,000 |
| Prepaid Insurance | $3,500 |
| Liabilities | |
|---|---|
| Accounts Payable | $22,000 |
| Supplies Expense/Payable | $17,500 |
| Utilities Expense/Payable | $8,000 |
| Salaries and Wages | $25,000 |
Include short-term assets and short-term liabilities (except for cash, financial investments, and interest-bearing liabilities) to calculate OWC. Since we’re calculating the operating working capital, we don’t have to include long-term liabilities and long-term assets like real estate.
The OWC calculation for the above would work as follows:
(Account receivable + inventory + prepaid rent + prepaid insurance) – (Supplies expense + utilities expense + salaries and wages)
= ($17,000 + $44,000 + $9,000 + $3,500) - ($17,500 + $8,000 + $25,000)
= $73,500 - $50,500
= $23,000
Operating Working Capital vs. Net Working Capital: Key Differences
As mentioned above, operating working capital is calculated as operating current assets minus operating current liabilities. On the other hand, net working capital (NWC), or just working capital, is the difference between the total current assets and total liabilities of a business.
Main differences between operating working capital and net working capital:
OWC measures how much equity a business has in the form of current assets. In contrast, NWC measures a company’s financial health and profitability.
OWC shows a company’s operational efficiency, while NWC shows how efficient a company is in using its capital to invest in money-making activities.
OWC focuses on day-to-day operations, while NWC gives the overall view of the company’s assets and liabilities.
OWC indicates whether a company can cover its short-term obligations. In contrast, NWC indicates a company’s creditworthiness in the long run.
How Do Working Capital Loans Work?
A working capital loan is a type of financing that provides funding to businesses to cover operating expenses. Business owners can use working capital loans to pay salaries and wages, pay income taxes, purchase inventory, buy materials and supplies, pay prepaid expenses, and pay utilities and rent.
This form of funding isn’t for long-term investments, such as buying real estate, but it’s really helpful when trying to keep your business afloat during downturns or emergencies.
Working capital loans can help you:
- Manage seasonal peaks when you need to buy more inventory and hire extra workers.
- Bridge seasonal gaps when inventory turnover is down, business is slow, and you have less incoming capital.
- Pay bills while you wait for your customers to pay off invoices.
- Improve business operations, such as maintaining or repairing broken equipment.
- Take advantage of money-making or money-saving opportunities, such as fulfilling an extra large order or securing bulk discounts from a supplier.
When funds are tight and cash flow is low, working capital loans can provide quick and easy funding for businesses to cover operational expenses. This gives business owners a chance to catch up until sales pick up or customers pay their invoices.
Working capital loans are also easier to qualify for, and you can apply through traditional banks and online lenders. However, online lenders may have fewer documentation and qualification requirements.
Working capital loans also tend to have more flexible terms than traditional small business loans. Since they’re mostly unsecured loans, you don’t have to put down collateral to guarantee them.
Types of Working Capital Loans
You can apply for several different kinds of loans, including:
Short-term loans. As the most common form of working capital financing, a short-term loan provides borrowers with a fixed loan amount. The loan plus interest is paid back in regular monthly payments for a specified term length.
Business line of credit. A business line of credit gives you access to an account with a set credit limit that you can use on an as-needed basis. It works the same as a credit card or home equity loan. You only incur interest and pay back the amount you withdraw.
Invoice factoring. Invoice factoring is a financing option that allows you to borrow money by using your accounts receivable as collateral. Some invoice factoring companies will advance up to 99% of your invoice amount upfront. The lender gets their money back when they collect invoice payments from your customers. You pay a factoring fee for the service.
Merchant cash advance (MCA). Like invoice factoring, a merchant cash advance gives you money upfront in exchange for a percentage of your future credit card sales. The lender looks at your company’s creditworthiness, future sales, and past credit card receipts to negotiate your factor fee. Your payments are automatically deducted from your daily or weekly sales transactions.
Discover the Best Working Capital Loan Options From Clarify Capital
Your company needs working capital to fund its day-to-day operations and meet its short-term obligations. When funds are tight and cash flow is low, working capital loans can provide quick and easy funding for businesses to cover operational expenses.
Working capital loans give you access to loans with flexible payment terms, and the application process is quick and easy. Most loans are unsecured, so you don’t have to put down any collateral.
When you work with Clarify Capital to secure your working capital loan, you’ll be partnered with a dedicated adviser who will guide you throughout the process. They’ll help you choose the best financing option based on your business needs.