Working capital turnover, also known as net sales to working capital, is an efficiency ratio used to measure how the company is using its working capital to support a given level of sales. This ratio shows the relationship between the funds used to finance the company’s operations and the revenues a company generates in return. Working capital turnover measures how efficiently the company is utilizing its working capital to produce a certain level of sales.
In other words, this ratio shows the net sales generated as a result of investing one dollar of working capital.
Working capital is very instrumental in running the day-to-day activities of a business. It is the amount of money that ensures that the business can pay its short term debts and bills like employees’ salaries.
Working capital refers to the cash at hand in excess of current liabilities that the business can use to make required payments of its short term bills. This ensures that everything is operating smoothly. Simply put, it’s that amount in hand in excess of current liabilities.
A high working turnover ratio is an indicator of the efficient utilization of the company’s short-term assets and liabilities to support sales. This means that the company is majorly depending on its working capital to generate revenues. A high ratio indicates that the company is making sales with very little investment.
Conversely, a low ratio implies that the company invests in accounts receivable and inventories to support its operations. This could be associated with the risk of stocks being outdated and accounts receivable being bad debts and being written off.
Working Capital Turnover Ratio Formula
Net sales are the gross sales less any sales returned. Working capital is calculated as current assets minus current liabilities, which is represented by the summation of accounts receivable and inventories less accounts payable.
Working capital used in this context is the average figure for one year to cover the fluctuations and seasonality in sales across the year. To calculate the average working capital, you sum the opening working capital and closing working capital then divide by 2:
However, if only closing balances of current assets and current liabilities are known and beginning working capital is not known, then working capital at the end of the period (closing working capital) may be used instead of the average working capital.
In scenarios where the net sales figure is not available, the cost of goods sold is always preferred as a proxy for net sales. The argument here is that COGS has more direct relations to the efficiency with which the working capital is used in the business. This leads us to another formula:
You can calculate COGS by subtracting gross profit from net sales. Or you can add opening stock and purchases, then subtract closing stock.
All this information required for the working capital turnover ratio is available from the company’s financial statements.
Working Capital Turnover Ratio Example
BGT Co Limited is a rapidly growing retail company in China, selling with food and beverages. In the fiscal year 2017, the company published in its financial statements:
- Sales: $350,000
- Returns: $70,000
- Net Sales: $350,000 – $70,000 = $280,000
- Opening WC: $100,000
- Closing WC: $180,000
First, let’s calculate the average working capital:
[Average\: WC = \dfrac{100{,}000 + 180{,}000}{2} = \$140{,}000[/latex]
Now we can calculate the working capital turnover ratio:
This company has a working capital turnover ratio of 2. This means that for every one dollar invested in working capital, the company generates $2 in sales revenue.
Working Capital Turnover Ratio Analysis
The working capital turnover ratio is an efficiency and activity ratio. It’s used to gauge how well a company is utilizing its working capital to generate sales from its working capital. It reveals to the company the number of net sales generated from investing one dollar of working capital. The ratio can as well be interpreted as the number of times in a year working capital is used to generate sales.
As a rule of thumb, the high ratio shows that the management is efficiently utilizing the company’s short term assets. They’re supporting sales. Meanwhile, a low ratio is a sign of power management of the business resulting in the accumulation of inventories and accounts receivable. When the ratio is low, it implies that the goods can’t be traded. Hence, they’re taking longer to be converted into cash leading to sales on credit. Thus, too many accounts receivable are generated. This can become a blow to the company. The inventory becomes outdated and accounts receivable become written off as bad debt.
Just like other measures, the working capital inventory ratio varies widely across and between industries and companies; therefore, for comparison purposes, compare a company’s working capital turnover ratio against the industry’s average or against their own historical data.
Working Capital Turnover Ratio Conclusion
- Working capital turnover ratio is an analytical tool used to calculate the number of net sales generated from investing one dollar of working capital.
- High working capital turnover ratio is an indicator of efficient use of the company’s short-term assets and liabilities to support sales.
- Low inventory to working capital turnover ratio implies that the company is not generating sales sufficient enough from the working capital available.
- Working capital turnover ratio requires two variables: net sales and average working capital.
- The ratio is interpreted in terms of dollars or time.
Working Capital Turnover Ratio Calculator
You can use the working capital turnover ratio calculator below to quickly calculate the number of net sales generated as a result of investing one dollar of working capital by entering the required numbers.
FAQs
What is a working capital turnover ratio?
The working capital turnover ratio is a measure of how efficiently a company is using its working capital to generate sales.
How do you calculate the working capital turnover ratio?
The working capital turnover ratio is calculated by dividing the net sales by the average working capital.
What is the advantage and disadvantage of the working capital turnover ratio?
The advantage of the working capital turnover ratio is that it can be used to gauge how well a company is utilizing its working capital to generate sales and it can be interpreted in terms of dollars or time.
The disadvantage of the working capital turnover ratio is that it varies widely across and between industries and companies; therefore, for comparison purposes, compare.
What is a good working capital turnover ratio?
A good working capital turnover ratio is high and indicates that the company is using its short-term assets and liabilities to support sales.
What does a negative working capital turnover ratio mean?
A negative working capital turnover ratio means that the company is not generating sales sufficient enough from the working capital available. This can be a sign that the company is not efficient in its use of working capital.
