The working capital turnover ratio measures the efficiency of a company’s ability to turn working capital into revenues as a result of its operations. With a clear understanding of this metric, business managers can track the revenues created for every dollar of working capital.
What Is the Working Capital Turnover Ratio?
The working capital turnover ratio compares a company’s net sales to its working capital. The comparison shows how efficiently a company is converting its working capital dollars into revenue.
The Formula for Working Capital Turnover
You can determine the working capital ratio by dividing the net annual sales by the average working capital. Here’s what the formula looks like:
Net Annual Sales / Average Working Capital = Working Capital Turnover Ratio
How to Calculate the Working Capital Turnover Ratio
Here’s how to put that formula into action.
Calculate average working capital: You can determine working capital by subtracting short-term liabilities from the company’s assets. Assets include notes receivable, prepaid expenses, and cash. Liabilities include accounts payable, wages payable, taxes, expected debt payments, dividend payables, and unearned revenue. You can find this number at multiple points during the year to find an average.
Calculate net annual sales: Find the net annual sales for your company by looking in your books. Or you can calculate the number by subtracting the cost of returns, allowances, and discounts from your company’s gross sales.
Divide net annual sales by average working capital: At this point, you’ll find the working capital turnover ratio.
An Example Calculation of the Working Capital Turnover Ratio
Here’s a closer look at an example:
Calculate average working capital. Let’s say that your company had a working capital of $10,000 in March, $15,000 in June, $10,000 in September, and $20,000 in December. With that, your average working capital is $11,500.
Calculate net annual sales: Let’s say your company saw gross annual sales of $100,000. But discounts, returns, and allowances added up to $10,000 for the year. With that, your net annual sales were $90,000.
Divide net annual sales by average working capital: Finally, we can divide $90,000 by $11,500. That leads to a working capital turnover ratio of 7.83.
What Does the Working Capital Turnover Ratio Tell You?
The working capital turnover ratio tells you how quickly your company can turn a dollar of working capital into a profit. Additionally, you can see how big of a profit one dollar of working capital can translate into.
Interpreting the Working Capital Turnover Ratio
After you run the numbers, it’s time to interpret the working capital turnover ratio. Here’s where the number could fall:
Generally, companies prefer to see a high turnover ratio. But the right balance depends on your goals. If you prefer slow growth, a low turnover might be preferred for your strategy.
Pros and Cons of High Working Capital Turnover
Turning assets into sales sounds like a good thing. And it is! But as with every financial metric, there are advantages and disadvantages tied to a high working capital turnover ratio.
Let’s start with the pros:
Smooth operations: A high working capital turnover indicates that a company is running efficiently.
Competitive edge: If your working capital turnover is above the industry average, that can give you an edge.
Now for the cons:
Potential funding needs: If your company is turning its resources into sales too quickly, it might need a cash influx to continue growing.
Cash doesn’t stay on hand: If the money is constantly turning over, an emergency expense could push everything off balance. Depending on the situation, it could lead to insolvency.
Advantages and Disadvantages of Using the Working Capital Turnover Ratio
The working capital turnover ratio is one of many metrics you can use the assess the health of your business. In most cases, it’s not the only metric you should look at. Let’s explore the advantages and disadvantages of using this accounting principle.
Advantages of Using the Working Capital Turnover Ratio
Starting with the advantages:
Guarantees liquidity: Regularly monitoring your working capital can help you avoid running out of money. It’s easy to spot liquidity problems if you constantly check into this ratio.
Enhances financial health: Typically, tracking this ratio encourages you to make changes that improve the overall financial health of the company.
Boost the company’s value: A high working capital turnover indicates efficiency, which can increase the value of the company.
Prevents disruptions: If your company is very efficient, it’s likely to avoid operational interruptions. That’s especially true if you are keeping an eye on the working capital.
Increases profitability: As you increase your working capital turnover ratio, that can lead to more profits with the tweaks you make along the way.
Disadvantages of Using the Working Capital Turnover Ratio
Of course, there are also some disadvantages to using the working capital turnover ratio:
Doesn’t look beyond monetary factors: Monetary factors have a big impact on your company’s bottom line. But other non-monetary factors can influence the overall financial health of the company. For example, unhappy employees or a recession on the horizon aren’t accounted for.
Open to misinterpretation: It’s easy to misinterpret a working capital turnover ratio. Although a high ratio is usually good, it can sometimes indicate unsustainable sales growth.
The Best Ways to Use the Working Capital Turnover Ratio
The working capital turnover ratio isn’t the only metric you should look at. But it can come in handy for two situations:
Monitor changes over time: An effective way to use this measurement is by comparing the current numbers to your business’s past. It’s helpful to see if this ratio is trending up or down. Typically, an upward trend means your business is increasing its efficiency.
Industry benchmarks: You can compare your company’s working capital turnover ratio to other companies in the industry. It’s often useful to see how you stack up against the competition.
FAQs about the Working Capital Turnover Ratio
Have questions about the working capital turnover ratio? We have answers.