What is operating working capital?
Operating working capital (OWC) measures a company's short-term financial health and operational efficiency.
To calculate OWC, you subtract current assets from current liabilities in a company's day-to-day operations.
A positive OWC suggests the company can meet its short-term obligations, while a negative OWC may signal potential financial difficulties. It means that a company has enough short-term assets to cover its short-term liabilities.
Cash and cash equivalents, debt and debt-like items are excluded from the operating working capital formula. These items are part of net debt.
How to calculate operating working capital?
To calculate a company's operating working capital, you subtract the operating current liabilities from the operating current assets.
Operating Working Capital (OWC) = Current Assets – Current Liabilities
Here are examples of the most common operating current assets and operating current liabilities:
Current Assets
Accounts receivable
Inventory
Prepaid expenses
Current Liabilities
Accounts payable
Accrued expenses
Deferred revenue or prepayments received
Remember, cash and cash equivalents, as well as debt, are excluded from the operating working capital formula.
Why cash and debt are excluded
Cash and debt are excluded from the operating working capital formula for the following reasons:
Cash and cash equivalents are not a part of a company's ability to generate cash flow. Even though cash is a current asset, it's not included in the operating working capital calculation because it's a non-operating asset. A company's cash can be invested in machinery or marketable securities. So, cash is "working" or bound in any way related to buying and selling goods.
Debt: Debt drawdown and repayment are recognized in the "Cash Flow from Financing" activity. It's a financial liability and does not relate to a company's operations and cash-generating ability.
Understanding operating working capital
Positive and negative working capital can have different implications for a business:
Positive working capital
This shows that a company has more current assets than current liabilities. Sufficient working capital is crucial for a company as it can meet its short-term financial obligations. Positive operating working capital is an excellent first indicator of a company's liquidity. However, an excess working capital in unsold inventory or uncollected receivables from previous sales suggests operational inefficiencies.
Negative working capital
Negative working capital happens when a company's current liabilities surpass its current assets. This suggests that the company isn't making enough money (accounts receivables) to pay for its inventory and (suppliers) accounts payables.
In all scenarios, it's crucial to maintain an optimal level of working capital that strikes a balance between financial robustness and efficient investment utilization.
What is a good operating working capital?
Ideally, you want the total amount of operating working capital to remain stable or to decrease without hurting operations. Meaning the company's liquidity requirements stay constant or decrease. You want smooth operations.
You don't want to see a lot of fluctuations in OWC. This means that the company may have unpredictable liquidity requirements.
Working capital is usually measured as a percentage of sales. The percentage tells a business how much of every sales dollar must go toward meeting operational expenses and short-term liabilities. For example, if OWC is 20% of sales, 20 cents of every 1 sales dollar are needed to fund operating working capital.
Ideally, that percentage stays stable without any fluctuations throughout the year. However, if the company grows, more revenue translates to more operating working capital.
Instead of thinking about good or bad levels of operating working capital, it makes more sense to think of home OWC as enough to guarantee operational efficiency.
How to improve operating working capital?
Improving your company's working capital is vital for future growth and can be achieved through several strategies:
Accelerate receivables collection: Don't wait until the end of the month to send the first invoice. A responsible customer will pay an invoice when it's received. Also consider shortening your payment terms. That way, your invoices are sent you out timely and payment should happen swiftly. Both are measures to decrease working capital.
Delay supplier payments: While maintaining good relationships with suppliers is essential, negotiating longer payment terms can help improve your working capital.
Inventory management: Efficient management of inventory can free up working capital. This involves reducing the investment in inventory through optimizing the sales and operational planning process.
What's the difference between operating working capital and net working capital?
Operating Working Capital (OWC) and Net Working Capital (NWC) measure a company's short-term liquidity, but they focus on different aspects.
Operating Working Capital
Operating Working Capital (OWC) refers to a company's current assets. It measures the company's investment to fund components of its operating cycle or day-to-day operations. This includes buying and selling inventory, paying suppliers and collecting payments from customers. Cash and short-term debt are excluded from this calculation. Even though cash is a current asset, it's not included in operating working capital because it's a non-operating asset.
Net Working Capital
Net Working Capital (NWC) includes all current assets and current liabilities, which consists of all items that need to be adjusted in the cash flow statement. This includes non-operating items, such as income tax liabilities, VAT tax receivables, provisions for vacations and bonuses, or prepaid expenses.
Net working capital is a more expansive definition as it includes all current assets and current liabilities. On the other hand, operating working capital focuses on the assets and liabilities directly linked to a company's day-to-day operations. It is more specific.
