What is Operating Capital? Why It is Important?

Companies and businesses depend on cash flows to operate efficiently. These cash flows arise from several sources and also go into many more. Although profits are an essential metric to measure a company’s success, cash flows also play a critical role. Companies that suffer from poor cash flow management don’t survive for long despite being profitable.

Similarly, managing liabilities and assets is crucial in allowing companies to survive. Furthermore, short-term assets and liabilities are as critical as long-term ones. There is a specific term used to describe both of these. It is known as operating capital or working capital and is crucial for a company’s success. The importance of operating capital is undoubtedly significant for companies.

What is Operating Capital?

Operating capital defines the cash companies use for daily operations. Companies rely on various financial resources to be successful. Similarly, one of these includes cash. However, several other factors contribute to a company’s cash resources. For companies, it is crucial to manage current assets and current liabilities properly to ensure the availability of these resources.

It is also known as working capital, which represents the difference between a company’s current assets and current liabilities. It determines a company’s ability to meet its short-term obligations and operational needs. Therefore, it represents a company’s residual current assets after deducting its current liabilities. This residual amount signifies the resources available for a company’s operational needs.

It is a critical metric for companies and their stakeholders. It helps these entities gauge a company’s ability to repay its short-term financial obligations using short-term resources. Both of these contribute to how liquid a company and its resources are. However, they go opposite each other. After calculating this amount, it helps provide an overview of a company’s short-term financial health.

As a whole, it provides an insight into a company’s liquidity position. This amount can either be positive or negative. If a company’s current assets exceed its current liabilities, operating capital will be a positive amount. In contrast, if the current liabilities outweigh the current assets, the operating capital will be negative.

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How to calculate Operating Capital?

Operating capital is the cash available for a company’s operations. However, its calculation depends on its current assets and current liabilities. It represents a company’s short-term financial health or liquidity position. It is the difference between a company’s current assets and current liabilities. Therefore, the formula for operating capital is as below.

Operating Capital = Current Assets – Current Liabilities

Both a company’s current assets and current liabilities are available in its balance sheet. Some companies may also expand the above formula and include several items within each of these components. This way, companies can calculate their operating capital without having to prepare a balance sheet. For example, current assets may include accounts receivable, cash and cash equivalent, inventory, etc. Similarly, current assets may contain accounts payable, accrued expenses, overdraft, etc.

Overall, calculating a company’s operating capital is straightforward. The operating capital formula above provides a reliable method of calculating this metric. Both internal and external parties can use this formula to measure a company’s working capital. Once calculated, it can also be a part of various other metrics.

Example

A company, ABC Co., has the following current assets.

ParticularsAmount
Short-term investments $     100,000
Accounts receivable $     350,000
Prepaid expenses $        50,000
Inventory $     400,000
Cash and bank balances $     150,000
Total $  1,050,000

It’s current liabilities included the following balances.

ParticularsAmount
Short-term debts $     365,000
Accounts payable $     300,000
Accrued expenses $     160,000
Income tax payable $     135,000
Bank overdrafts $        50,000
Total $  1,010,000

Therefore, ABC Co.’s operating capital will be as below.

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Operating Capital = Current Assets – Current Liabilities

Operating Capital = $1.05 million – $1.01 million

Therefore, Operating Capital = $40,000

ABC Co.’s current assets exceed its current liabilities by $40,000. The company can use this amount in its operations. The use of these assets will depend on the company’s requirements. However, this metric does not provide a meaningful result on its own. Companies must either use it in comparison or as a part of other metrics to get better results.

What are the components of Operating Capital?

From the above formula, it is clear that there are two fundamental components to the operating capital. These include a company’s current assets and current liabilities. Understanding operating capital better requires studying what each of these two components is.

Current Assets

Current assets represent a company’s short-term assets. These are assets that usually last for 12 months or less. However, these also refer to a company’s liquid assets. In other words, current assets are all resources that a company can readily convert into cash within 12 months. When classifying current assets, it is crucial to separate them from non-current assets, which are resources that last more than 12 months.

Current assets usually come from a company’s operations. Therefore, they play a critical role in operating capital. There are several items that may be a part of a company’s current assets. These include accounts receivable, inventory, prepaid expenses, short-term investments, and cash and cash equivalent. Similarly, they are all assets that companies can liquidate within 12 months or less.

Current Liabilities

Liabilities are obligations that companies owe and will result in a future outflow of economic benefits. Current liabilities are a classification of these obligations into those that are repayable within 12 months. Therefore, a company’s current liabilities represent any debts or overdue amounts with expected settlement within a year.

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Current liabilities also generate due to a company’s operations. Therefore, these also impact a company’s operating capital. Furthermore, these do not include obligations that require settlement after 12 months, usually known as non-current assets. Current liabilities include balances, such as accounts payable, income tax payable, bank overdrafts, short-term debts, lease payable, etc.

What is Operating Capital important?

Operating capital represents a crucial resource for companies and businesses. It describes a company’s preparation for its current liabilities in terms of its current assets. Overall, it helps companies and stakeholders gauge a company’s liquidity position. Similarly, it provides insights into how a company uses its current assets and current liabilities efficiently.

It plays a crucial role in helping companies survive in the short term. By doing so, they also prevent any long-term issues. If a company does not have any operating capital, it will face cash flow shortages and operational stoppage. On the other hand, companies that hold operating capital can prosper in both the short and long term.

It also allows companies to calculate whether they have a cash surplus or deficit. If a company has a positive operating capital, it will have a cash surplus. A negative operating capital will represent a cash deficit. If companies experience a continuous cash deficit, it may be an indicator of long-term cash management issues.

However, it does not present any meaningful information on its own. Usually, companies must use it comparatively or as a part of other metrics. By doing so, however, companies get better insights into various aspects of their operations. The operating capital is one of the most critical metrics used for a company’s short-term financial health.

Conclusion

Operating capital represents the cash companies can use for operations. It is the difference between a company’s current assets and current liabilities. Both of these components play a vital role in operating capital. For companies, it is significantly important. It is also helpful in comparisons and calculating other dependent metrics.

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