Top Stories | Tue, 24 Dec 2024 10:43 AM

Operating Working Capital: Key Metrics and Its Impact on Business Liquidity

Posted by : SHALINI SHARMA

Operating working capital, or OWC, is an important measure of short-term financial health and liquidity in a company. It means the capital needed for a business to run its everyday operations, thus enabling the business to meet its short-term obligations while ensuring sufficient liquidity. Understanding the different components of operating working capital and how they affect liquidity is important for businesses regardless of their size.

What is Operating Working Capital?

The capital a firm requires to run its daily operations is referred to as operating working capital. It can be defined as the difference between current assets and current liabilities, excluding cash and short-term debt. Here, the emphasis is placed on assets and liabilities directly related to the business's operations.

Mathematically, operating working capital can be represented as:

Operating Working Capital (OWC)=Accounts Receivable + Inventory−Accounts Payable

Accounts Receivable: Money owed to the business by customers for goods or services delivered.

Inventory: The goods and materials a business holds to sell or use in production.

Accounts Payable: Money the business owes to its suppliers for goods and services purchased on credit.

Important Metrics to Watch in Operating Working Capital

To gauge operating working capital properly, a few important metrics to monitor are:

Days Sales Outstanding (DSO):

DSO measures the average number of days it takes a business to collect payment after a sale. The higher the DSO, the more time a business is taking to convert its receivables into cash, which could negatively affect liquidity.

DSO= Average receivable / total sales * 365

Days Inventory Outstanding (DIO)

DIO is a measure of the average number of days it takes for a company to sell its inventory. The higher the DIO, the longer a business holds onto its inventory, which ties up cash and reduces liquidity.                                    

DIO= Inventory / Cost of Goods Sold ×365

Days Payables Outstanding, or DPO:

A DPO measures the duration in days that a firm takes to pay its suppliers. In other words, high DPO means a higher period of holding onto money due to delayed payment but would increase liquidity; therefore, too high DPO would strain supplier relationships.

DPO= Accounts Payable / Cost of Goods Sold ×365 

The Impact of Operating Working Capital on Business Liquidity

Business liquidity is maintained by operating working capital. If accounts receivable, inventory, and accounts payable are managed well, the business can optimize cash flow to avoid the likelihood of running into liquidity issues. Here's how various components of OWC have an impact on liquidity:

Accounts Receivable: The longer it takes to collect from customers, the more cash is tied up in AR, thereby reducing the available liquidity for other business activities. High DSO can signal that a business needs to improve its credit and collections policies to ensure quicker payments.

Inventory: Excess inventory ties up cash in goods that are not yet sold. A business with high levels of inventory might suffer liquidity issues, especially if the inventory is slow-moving. Optimization of inventory levels by improving demand forecasting and implementing just-in-time practices will free up cash and enhance liquidity.

Accounts Payable: On the other hand, the stretching out of payments to suppliers (i.e., increasing DPO) would temporarily boost liquidity as it keeps the cash in the business. However, the payments should not be stretched out for too long so that relationships with suppliers would not be damaged and consequently lead to unfavorable terms later on.

Managing Operating Working Capital to Improve Liquidity

To achieve good liquidity, companies should balance and optimize the operating working capital structure. Here are some strategies that can improve the management of OWC.

Enhance Receivable Collection: Credit policies be strictly implemented. Early payment discounts should be offered by giving incentives. Overdue invoices should be followed through within the proper time; DSO would be cut, and cash flow increases.

Optimize Inventory Level: Adopt lean inventory practices, enhance demand forecasting and make use of technology for stock level tracking. Managing lower inventory turnover can save the cash tied up in unsold goods.

Obtain Better Payment Terms: Engage with suppliers and push for longer payment terms, yet maintain good supplier relations. This will push up DPO, enhancing the liquidity position.

Closely Monitor OWC Metrics: DSO, DIO, and DPO should be constantly monitored to ensure that operating working capital is managed efficiently. A business can make real-time adjustments to its operations based on data-driven decisions to address liquidity issues.

Conclusion

Operating working capital is a critical measure of a company's liquidity and operational efficiency. With this understanding, monitoring the components, businesses would be able to get ample cash flow for current obligations, investments in growth opportunities, and managing crises of finances. The optimizing OWC is achieved in balance, where there's careful attention to timely collections by customers, reducing stock quantities, and ensuring proper supply terms. The success in managing operating working capital goes a long way toward sustainability in financial health, especially in the smooth functioning of business operations.

By focusing on OWC and improving these core areas, businesses can improve their liquidity position and maintain a competitive edge in the marketplace.