Importance of Operating Capital in Business

Operating Capital – Definition

Operating capital is defined as the cash required for running the daily operations of the company. Successful business operations rely on the availability of raw materials and financial resources. These are collectively referred to as operating capital. Also known as working capital, it determines the ability of a company to meet its short-term obligations and production targets. Without adequate working capital in hand, a company’s business operations are adversely impacted. Thus, in a way, operating capital is a measure of a company’s operating efficiency and short-term financial health.

Importance of Operating Capital

Operating capital is one of the critical assets of any business organization. Its improper planning can result in the breakdown of the business. Take, for example, a manufacturing firm ABC which manufactures sports goods. To run the business, ABC requires purchasing raw materials, viz. wood, plastic, rubber, etc., which would require cash (let us assume here that ABC cannot borrow money). Also, once a raw material is in place, ABC requires workers to run the machines and convert the raw material into finished goods. Electricity, water, oil and lubricants, packaging material, etc., would be other things without which production is incomplete. This capital would thus be a sum of all these expenses put together. Inadequate supply of the same can lead to a breakdown of production and, therefore, losses to the business.

Operating Capital

Whether small or large, the operating capital keeps the business going on in the short term. Due to this fact, businesses give key importance to planning and monitoring a flow of operating capital. They maintain accounts on a daily basis to keep a check on the appropriate availability of operating capital.

Operating or Working Capital Formula

The formula for calculating working capital is very easy. It is the difference between current assets and current liabilities.

Working Capital = Current Assets – Current Liabilities

Those assets that can convert into cash within a period of one year are current assets. These would include cash, stock, short-term advances, marketable securities, etc. Similarly, business obligations that are to be paid off within a span of one year are called current liabilities. Obligations such as expenses payable, short-term debt, and unpaid taxes are some common examples of current liabilities.

If current assets are more than the company’s current liabilities, it means that working capital is available. However, whether that much operating capital meets the requirements of the company or not is another question. If current assets are less than the current liabilities, it is an alert for the business. It means that a business requires capital infusion. The capital infusion can take the form of owner’s equity or bank borrowings.

Calculating Working Capital – Example

Take for example, current assets of a firm XYZ is $2,000,000 and current liabilities are $1,250,000. We can calculate operating capital as follows –

Operating Capital = $2,000,000 – $1,250,000 = $750,000

Thus, the operating capital of the firm XYZ is $750,000. This is the capital in hand for XYZ. XYZ can use this for paying off operating expenses.

Capital Vs. Operating Budget

Operating capital is of critical importance for the financial health of a business organization. Therefore, to plan and monitor its requirements, a company prepares budgets. Budgeting is a simple exercise of balancing expenses with income. A budget to plan operations of the company by balancing its revenues against its expenses is called an operating budget. A smaller company may require a single operating budget, while a big company may require preparing operating budgets division-wide later on, consolidating them into one company-wide budget.

One should not confuse Operating Budget with Capital Budget. Though having similar names, the purpose of preparing both budgets is different. A company may want to invest in long-term assets. For this, a company requires large sums of capital. It prepares capital budgets to address such sudden business requirements. A capital budget normally spans a period of more than 1 year, while an operating budget covers one fiscal year.

Operating capital plays a very important role in running the day-to-day operations of a business. Adequate and timely supply of working capital ensures that business operations are running smoothly. Companies can also borrow loans from banks to ensure that there is no dearth of working capital. Businesses, whether large or small, can approach banks for working capital loans.

Conclusion

Operating capital plays a very important role in running the day-to-day operations of a business. Adequate and timely supply of working capital ensures that business operations are running smoothly. Companies can also borrow loans from banks to ensure that there is no dearth of working capital. Businesses, whether large or small, can approach banks for working capital loans.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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