Understanding operating working capital is pretty much a necessity to avoiding falling into debt. As the term implies, your operating working capital (OWC) – sometimes (and somewhat mistakenly) called a net operating working capital (NOWC) – is an indication of how much capital you actually have at your disposal once your liabilities are factored into the equation. Indeed, there is literally an equation to help you manage your OWC. Following is a succinct guide to OWC, a simple OWC equation and ratio and the best way to manage your assets and liabilities. Pick up more business planning knowledge with this great course on how to budget and forecast for your business.
Operating Working Capital: Staying Current
The primary focus of OWC is in the relatively short-term; approximately one year or so. Anytime capital or assets are discussed in such short time frames they are referred to as “current.” A working capital, for obvious reasons, must be current. You cannot have a working capital that includes investments that will not be realized for ten years.
The two main variables in calculating working capital are assets and liabilities; or rather, current assets and current liabilities. Again, these are only assets and liabilities that will be, or can be, active within one year’s time.
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Why OWC Is Important
It’s very simple: if your current liabilities exceed your current assets, they you are walking a very fine line between investing all of your money back into your company and falling into trouble with your creditors. Of course, if things continue to worsen, bankruptcy inevitably results.
OWN is also important in determining the day to day efficiency of a company. The flexibility of a company’s current assets determines how smoothly it can operate on a consistent basis. If a company has too much capital invested in non-current assets, it can run into trouble by not being able to access that money in the case of a financial emergency. If the gap between current and non-current assets increases over time, this is an indication of neglect and poorly managed bookkeeping. Immediate analysis and intervention should be implemented.
The equation itself could not be simpler. Making it accurate, however, is a matter for a very adept accountant. If your bookkeeping isn’t in order, then it will be literally impossible to calculate an OWC. Get all the help and information you need with this top-rated, small biz doers’ guide to small biz bookkeeping.
Now, the equation:
Operating Working Capital = Current Assets – Current Liabilities
That’s it. As I said, the equation is simple if – and only if – you know the values of your current assets and current liabilities. As you can see, a positive number is what you’re shooting for (which would mean your assets would exceed your liabilities). But you don’t necessarily want the largest number possible. In fact, the best way of judging how well you are balancing your assets and liabilities is to calculate a working capital ratio.
Calculating Your OWC Ratio
The ratio is just as simple as the equation:
OWC Ratio = Current Assets / Current Liabilities
So again, an easy equation if you know the values of your assets and liabilities. Now, whether or not you have a thousand or a billion dollars of positive OWC is not as important as how balanced they are. You don’t want to have a bunch of assets that aren’t working for you (such as Apple is accused of doing with its $150 billion sitting in the bank). Learn how to invest intelligently and with confidence with this excellent course on the fundamentals of investments.
If the ratio is below 1 then your liabilities are excessive, i.e. exceed your assets. If the ratio is above 2, then your assets are excessive, i.e. you have too much money just lying around. You generally want to keep the ratio between 1.2 or 1.3 and 2.0. This way you have adequate day-to-day flexibility as well as a reserve of capital that you can call on if need be. It also means that you are investing the appropriate amount of money back into the company to catalyze growth. If you spend too much time on the wrong side of the ratio, you’re only handicapping yourself.
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