Understanding the Working Capital Turnover Ratio

What Is Working Capital Turnover?

Working capital turnover measures the relationship between funds that are used to finance a company’s operations and the revenues it generates to continue operations and turn a profit. A higher turnover ratio indicates efficiency and a fluid and sufficient cash flow. Working capital turnover is also referred to as net sales to working capital.

Working Capital Turnover Formula

$\begin{aligned} &\text{Working Capital Turnover}=\frac{\text{Net Annual Sales}}{\text{Average Working Capital}}\\ \end{aligned}$​Working Capital Turnover=Average Working CapitalNet Annual Sales​​

Where:

• Net annual sales are the sum of a company’s gross sales minus its returns, allowances, and discounts over a year.
• Average working capital is average current assets less average current liabilities.

What Does Working Capital Turnover Tell You?

A high turnover ratio shows that management is very efficient at using a company’s short-term assets and liabilities to support sales. It’s generating a higher dollar amount of sales for every dollar of working capital used.

A low ratio may indicate that a business is investing in too many accounts receivable and inventory to support its sales. This could lead to an excessive amount of bad debts or obsolete inventory.

Analysts also compare working capital ratios to those of other companies in the same industry to gauge just how efficient a company is at using its working capital. They look at how the ratio has been changing over time. Such comparisons are meaningless, however, when working capital turns negative because the working capital turnover ratio then also turns negative.

Working Capital Management

Working capital management commonly involves monitoring cash flow, current assets, and current liabilities through ratio analysis of the key elements of operating expenses. These include working capital turnover, the collection ratio, and the inventory turnover ratio.

Working capital management helps maintain the smooth operation of the net operating cycle, also known as the cash conversion cycle (CCC). This is the minimum amount of time required to convert net current assets and liabilities into cash. Financial insolvency can result and lead to legal troubles, liquidation of assets, and potential bankruptcy when a company doesn’t have enough working capital to cover its obligations.

Companies use inventory management and keep close tabs on accounts receivables and accounts payable to manage how efficiently they use their working capital. Inventory turnover shows how many times a company has sold and replaced inventory during a period and the receivable turnover ratio shows how effectively it extends credit and collects debts on that credit.

Important Considerations for Working Capital Turnover

A high working capital turnover ratio shows that a company is running smoothly and has a limited need for additional funding. Money is coming in and flowing out regularly, giving the business flexibility to spend capital on expansion or inventory. A high ratio may also give the business a competitive edge over similar companies as a measure of profitability.

An extremely high ratio might indicate that a business doesn’t have enough capital to support its sales growth, however. The company could therefore soon become insolvent if it doesn’t raise additional capital to support that growth.

Important

The working capital turnover indicator may also be misleading when a firm’s accounts payable are very high. This could indicate that the company is having difficulty paying its bills as they come due.

Example of Working Capital Turnover

Say that Company A has $12 million in net sales over the previous 12 months. The average working capital during that period was $2 million.

The working capital turnover ratio is therefore $12,000,000 / $2,000,000 = 6.0. Every dollar of working capital produces $6 in revenue.

How Does a Cash Conversion Cycle Work?

A company’s cash conversion cycle is an equation that adds its days of outstanding inventory and its days of outstanding sales and then subtracts the days that payables have been outstanding.

Days of outstanding inventory is the average number of days it takes the company to sell its inventory. Days of outstanding sales represent the average number of days it takes the company to collect on its receivables. Days for payables outstanding equal how many days on average it takes the company to pay what it owes.

The result indicates how long it will theoretically take a company to convert its inventory into cash. It can be used to compare companies but ideally only companies that fall within the same industry.

What Is Working Capital?

Working capital is simply the amount of current assets remaining on the balance sheet after a company’s current liabilities are subtracted. It’s a measurement of short-term financial health. A positive number typically indicates that the company has sufficient assets to pay off its short-term liabilities within the upcoming year.

What Is Obsolete Inventory?

Obsolete inventory is anything that’s held in stock that can no longer be used. It’s often the result of plummeting consumer demand for the products in question. Their costs must be either written down or written off the company’s books.

The Bottom Line

The working capital turnover ratio measures how well a company uses its working capital to sustain growth and sales. The equation to arrive at the ratio is basic and simple. A high ratio indicates financial efficiency. A low ratio can be a red flag indicating one or more problems. They may include investing in too many inventory-related expenses.

Working capital turnover ratios can be efficient and informative tools when evaluating companies but care should be taken that any companies are in the same industry and share the same inventory models.