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Working capital turnover is defined as a ratio that measures how effectively a company utilizes its working capital to support its sales and revenue growth. Working capital turnover is also known asNet Sales to Working Capital.
The ratio is a measurement that defines the relationship between the cost of a company’s operations and the corresponding revenue. The cost is all the funds utilized to finance the different operations. These operations generate revenue which in turn helps companies to continuously fund the operations and turn a sizeable profit.
On a scale, companies expect to generate a higher working capital turnover which indicates their ability to create more revenue compared to the cost spent.
You are probably wondering what working capital means. Working Capital refers to the difference between a company’s current assets and its current liabilities. Here, assets can be cash, receivable income like customer’s unpaid bills, and stocked inventory of raw materials and finished goods. Whereas, the liabilities can be all the payable or debt amount.
Working Capital = Current Assets - Current Liabilities
Simply put, working capital is the final amount left after a business pays up all their outstanding bills and short-term debts - that is all their liabilities. It indicates the capital that can directly be utilized to invest in expanding the company's operations and to support its growth.
It is also known as Net Working Capital. Working Capital, in essence, refers to a company’s liquidity and financial health. Positive Working Capital, means in the present, the company has more assets than liabilities, which is a good state to be in.
The Working Capital Turnover formula is as follows:
Working Capital Turnover = [Net Annual Sales / Average Working Capital]
Let’s take an example to understand how to calculate the Working Capital Turnover ratio better.
Here we have a company with the -
Net Sales over a year = $20 million
Average working capital = $5 million
Working Capital Turnover Ratio = 20/5 = $4
So, in the case of the given company, every dollar of working capital produces $4 of revenue.
A company’s Working Capital Turnover Ratio tells a lot about the company’s ability to generate results for the value spent. But what does a high or low working capital ratio imply from a financial standpoint?
A high turnover ratio implies that a company is being extremely efficient in using its working capital (short-term assets and liabilities) to support its efforts to generate more sales. That is the company generates a high revenue price for each dollar of working capital spent.
A low turnover ratio in turn implies that the return on working capital expenditure is low. That is the company is inefficient at producing revenue.
Here the company is probably handling too many account receivables, that is the due amount to be paid by a client or customer. With the burden of account receivables and mismanaged inventory, the liabilities and bad debts become excessive. Which in turn disallows companies to support their sales initiatives.
On the other hand, the capital turnover ratio can also be negative in cases when the working capital itself is negative. That is when current assets < current liabilities.
A high working capital turnover is overall a good thing. It means that the capital is flowing in and is being spent on activities to generate more revenue. But a very high turnover can be a problem. This is because a very high ratio implies that a business does not have enough capital to support sales growth. That is the yearly revenue is huge compared to the working capital. So there is a chance the company becomes insolvent in the near future. So companies should be careful to not ignore this outcome.
The turnover ratio, in a nutshell, gauges the efficiency of a company at using its working capital. So analysts prefer to compare the turnover ratio with other companies in the market and derive valuable insights from them.
Analysts also compare the ratio of past years to understand the trends and suggest improvements where ever necessary. Any trend dynamic can be studied further to understand how the financial health of the company is changing and what are the major drivers of that change.
Companies with a low turnover ratio have to find ways to increase it. It is important to solve this problem as soon as you can so there is no hindrance in the day-to-day operations. There are a few ways a company can increase its capital turnover which I have outlined below -