Working Capital Turnover Ratio Meaning, Formula, Calculation
Effective working capital management requires the use of ratios, such as working capital turnover and inventory ratios, among others. The use of these ratios provides insights into a business’s operations and highlights areas where improvements are needed. One effective way of managing working capital is by reducing payment terms, simplifying operations, and implementing better inventory management practices.
The average balances of the company’s net working capital (NWC) line items – i.e. calculated as the sum of the ending and beginning balance divided by two – are shown below. However, unless the company’s NWC has changed drastically over time, the difference between using the average NWC value and the ending balance value is rarely significant. To calculate the turnover ratio, a company’s net sales (i.e. “turnover”) must be divided by its net working capital (NWC). In practice, the working capital turnover metric is a useful tool for evaluating how efficiently a company uses its working capital to produce more revenue. The Working Capital Turnover is a ratio that compares the net sales generated by a company to its net working capital (NWC). The formula for calculating this ratio is by dividing the company’s sales by the company’s working capital.
Example of the Working Capital Turnover Ratio
The working capital cycle represents the period measured in days from the time when the company pays for raw materials or inventory to the time when it receives payment for the products or services it sells. During this period, the company’s resources may be tied up in obligations or pending liquidation to cash. In its simplest form, working capital is the difference between current assets and current liabilities. However, different types of working capital may be important to a company to best understand its short-term needs. Working Capital Turnover Ratio is a financial ratio which shows how efficiently a company is utilizing its working capital to generate revenue.
Working Capital Turnover Ratio
Another important factor to consider when interpreting the working capital turnover ratio is the seasonality of the business. For example, a retail business may have a higher ratio during the holiday season due to increased sales, but a lower ratio during slower months. It is important to take into account the timing of sales and the impact it may have on the ratio. An excessively high turnover ratio can be spotted by comparing the ratio for a particular business to those reported elsewhere in its industry, to see if the business is reporting outlier results. This is an especially useful comparison when the benchmark companies have a similar capital structure. As working capital is the money a company uses to run its daily operation, a company with negative working capital is not likely to last long.
- Negative working capital is a giant red flag for a company as it means that the company is in financial trouble and management needs to act immediately to source additional funding.
- It shows the number of net sales generated for every single unit of working capital employed in the business.
- A company’s working capital turnover ratio can also be used to identify trends and patterns in a company’s financial performance over time.
- UTX is clearly using its investment in working capital more efficiently as indicated by its higher working capital turnover ratio when compared to GE’s ratio.
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Working capital management also involves the timing of accounts payable like paying suppliers. A company can conserve cash by choosing to stretch the payment to suppliers and make the most of available credit. Companies primarily consider inventory during working capital management as it may be the most risky aspect of managing capital.
Since we now have the two necessary inputs to calculate the turnover ratio, the remaining step is to divide net sales by NWC. Suppose a business had $200,000 in gross sales in the past year, with $10,000 in returns. In particular, comparisons among different companies can be less meaningful if the effects of discretionary financing choices by management are included. The NWC turnover ratio can be interpreted as the dollar amount of sales created for each dollar of working capital owned. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance.
By measuring how efficiently a company uses its current assets to generate revenue, businesses can identify opportunities to optimize working capital management. working capital turnover ratio Monitoring and analyzing working capital turnover ratio is crucial to staying ahead of competitors, securing credit lines, and making informed business decisions. Hence, as a business person, understanding your company’s working capital turnover ratio is essential for long-term financial success.
It is one of the most critical elements within a company’s operation, as poor working capital management may lead to disaster. Using the assumptions above, the net working capital (NWC) equals the difference between operating current assets minus operating current liabilities, which comes out to be $95,000. In order words, assets such as cash and liabilities such as debt are financial assets that are not necessarily tied to the core operations of a company. Companies still need to focus on sales growth, cost control, and other measures to improve their bottom line. As that bottom line improves, working capital management can simply enhance the company’s position. Three ratios that are important in working capital management are the working capital ratio, the collection ratio, and the inventory turnover ratio.
Also, it may not reflect the company’s performance accurately if the sales and working capital levels fluctuate significantly during the measurement period. Though the company can part ways with its inventory, its working capital is now tied up in accounts receivable and still does not give the company access to capital until these credit sales are received. The AR cycle represents the time it takes for a company to collect payment from its customers after it has sold goods or services. The first is to compare the calculated ratio with the companies own historical records to spot trends. Secondly, this ratio is extremely useful as a benchmark when compared with its competitors since these companies sell similar products. A high Working Capital Turnover ratio is a significant competitive advantage for a company in any industry.
Several businesses have used working capital turnover ratio to analyze and improve their financial health. The technology giant has a high working capital turnover ratio, indicating efficient management of its current assets. By doing so, Apple has been able to boost its profit margins and returns on investment.
To match the time period of the numerator with the denominator, using the average NWC balances between the beginning and ending periods is recommended. The sales of a business are reported on its income statement, which tracks activity over a period of time. Even with the best practices in place, working capital management cannot guarantee success. The future is uncertain, and it’s challenging to predict how market conditions will affect a company’s working capital. On the positive side, this represents a short-term loan from a supplier meaning the company can hold onto cash even though they have received a good.
This can happen when the average current assets are lower than the average current liabilities. With strong working capital management, a company should be able to ensure it has enough capital on hand to operate and grow. The inventory turnover ratio is calculated as the cost of goods sold (COGS) divided by the average balance in inventory.
Accounting practices, tax laws, and regulations vary from jurisdiction to jurisdiction, so speak with a local accounting professional regarding your business. Reliance on any information provided on this site or courses is solely at your own risk. High – A high ratio is desired, it shows a high number of net sales for every unit of working capital employed in the business. However, a very high ratio is not desirable as it may signal that the company is operating on low working capital w.r.t revenue from operations. A concern with this ratio is that it reveals no useful information when a business reports negative working capital.
Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.
