Did you know that there are about 28 million small businesses in the U.S.? Are you a small business who wonders what operating capital is?
In this article, you’ll discover the answer to what is operating capital and why is it important? Read on to discover how it helps your business and why it’s so vital.
What Is Operating Capital and Why Is It Important?
Did you know that 70% of small businesses are run by one person? Operating capital is the difference between a small business’s current liabilities and assets. Currents assets can be items or cash. Examples of items are trade receivables, inventory, and checks that can be converted to cash. Current liabilities are short-term obligations. They’re bank overdrafts, loans that can be paid within a year, and trade payables.
If you want a successful business, you ideally want your assets to be higher than your liabilities. A good way to increase operating capital is by increasing your sales volumes, speeding up the conversion of inventory into cash, and speeding up debt collection. If you have negative operating capital that reflects trouble for your business.
Another name for operating capital is known as working capital. When you don’t have proper planning for your business it can lead to the breakdown of your business. To calculate your operating capital, it’s your current assets – your current liabilities.
Capital vs Operating Budget
Since operating capital is vital for your business, it’s important to plan for and prepare your budget. A budget that plans operations of the company by balancing expenses against its revenues is known as an operating budget.
For small businesses, you might just require one operating budget, but larger companies will require division-wide budgets later on that form into one company budget. Capital and operating budgets are different. If you want to invest in long-term assets you’ll need a large amount of capital.
A capital budget is normally more than 1 year, and an operating budget is normally just 1 year. Operating capital is crucial for running the daily operations of your business.
An option is to borrow a loan so you don’t have to worry about not having enough capital. Whether you’re a large or small business you can always explore more about working capital loans.
1. Make up for Sales Fluctuations
In any small business, you have to worry about sales fluctuating. You can have your operating capital as a backup in case of low sales during that time. If you don’t have operating capital, you’re more likely to not pay your bills and other debts which can hurt the credit of your business.
2. Evaluating Financing Decisions
Since the operating capital shows your current ratio, lenders will look at your operating capital to determine if you’ll honor your short-term obligations. You’ll want at least a minimum of 1 for liquid assets to prove you’ll cover short-term liabilities. You’ll also find it easier to take a look at financing for operational needs.
3. Helps Grow Your Business
It’s important to have a good amount of operating capital since you’ll have more flexibility to meet the needs of your customers. You can also expand your business and check out new opportunities. You can use the operating capital for services, new products, or to enter a new market.
4. Ensure Production Activities
Another benefit of operating capital is to make sure there’s a smooth production process when you have enough operating capital. You should have accounts receivables, cash, and inventory to help your ongoing production process and help any debt obligations.
This also lets you restock any inventory and allow credit sales without hurting your financial position.
Tips for Managing Operating Capital
You’ll want a plan to manage your operating capital. To do this and make sure you have enough funds between assets and current liabilities, you’ll need a management strategy. You’ll need to manage inventories, accounts payable, accounts receivable, cash, and any other related accounts.
You can also discover what aspects of your business you need to focus more on. This could be inventory turnover, operating capital ratio, and collection ratio. Always check the liquidity position of your business as well.
To optimize operating capital, there are a few steps you can take including reducing your business’s inventory. To reduce inventory you can get rid of non-value adding steps within the production process, have standardization of products, and have correct demand forecasting.
Increasing Payable Timeline
You can always speak with your suppliers about increasing your payables cycles for better terms. You can also have a positive cash flow by balancing payables and account receivables.
Quicker Payment Collection
Another option is to increase your operating capital by making sure to pay early and collect payments late. Send payment reminders and decrease grace periods, change payment terms and conditions for quicker payments, and have invoices issued faster.
Have Measurement Metrics
To optimize operating capital even more, have an effective program in place and make sure those in your organization in charge understand it. This will help you measure the fulfillment of goals and offer feedback. You can also check out analytics to optimize operating capital even more.
Understanding Operating Capital
Operating capital is essential for any business to understand how your business stands with assets vs liabilities, plus having a cushion in case of emergencies. Now you can answer the question of what is operating capital and why is it important? Are you ready to learn more about funding for your small business? Learn Strategic’s plethora of options for you and your business.
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