Liquidity ratios measure a company's ability to pay its short term debt obligations. To understand it properly, it's useful to understand terms such as operating working capital. Operating working capital or OWC looks at cash tied up in operations. A great example of this is inventory. If a company has spent 500 then that cash has left the bank, it's gone out to a supplier, the supplier has provided us 500 worth of inventory. That inventory now represents cash tied up in operations. But how do we calculate operating working capital? Well, operating working capital or OWC equals your operating current assets such as inventory, less operating current liabilities.

So OWC measures funds needed to maintain operations or cash tied up in operations. What kind of things does it include? Well, we know it's operating current assets such as accounts receivable or inventory, less operating current liabilities such as accounts payable.

So just to walk through a quick example here. Imagine I had 500 of inventory and 500 of accounts receivable. That's cash tied up in operations. Accounts receivable is cash tied up with my customers. But what if I also owed 10 to a supplier? Well that's really me tying up some of my suppliers cash. I've got my suppliers cash of 10 sitting in my bank, fantastic. So cash tied up would be the 500 of accounts receivable and 500 of inventory. That's a thousand of cash tied up, less than 10 of cash of my supplies that I've got. So my OWC in that example would be 990. Important to realize, though, all of these are operating balance sheet items. We're not going to be including financing balance sheet items. They are not included in OWC. So things like short-term and long-term debt, any loan notes, revolvers, overdrafts, all of these things might provide funding to my business but they're not cash tied up in operations. Instead, we get those figures from things like accounts receivable inventory and accounts payable.