There are several ways to determine the success or profitability of a business. You can find out information about its revenue generated in a particular period of time, say a year. Or you can look up the income it earned via a profit and loss statement. Net sales figures and the amount of profit are also indicators of how well a business has been doing.
But when you compare the business’s working capital to its turnover ratio for a fixed period, say for 6 months or a year, you get a more specific idea about how much each dollar used as working capital has earned for the business.
This is why the concept of working capital turnover and the working capital turnover ratio is important from the point of view of studying the current financial status of any business and determining its exact sales growth.
A simple definition of working capital is the amount of money or capital that goes into the day-to-day operations of a business. Working Capital is calculated as the difference between the company’s current assets less its current liabilities.
As an extension, the working capital turnover is expressed as a ratio. Simply put, it is the measure of net annual sales of a business in terms of the working capital needed for making those sales in a definite time period, usually a year.
If you wish to consider the average working capital, you need to sum up the various amounts of working capital used over a time period and then divide them by a single measure of the time period –in years or in months.
When you calculate the working capital turnover, it helps an individual determine how profitable a business has been in a fixed period of time –half-yearly or annually.
We have already seen that the working capital turnover is a measure or a ratio of the total sales of a business in a specific time period, 1 financial year, for example, divided by the total working capital needed or utilized during that year.
Calculation of the working capital turnover ratio formula is simple and easy. You simply divide net sales generated in a particular time period (a year, for e.g.) with the net working capital used in the same corresponding period of time.
The resultant ratio is your working capital turnover ratio. This working capital turnover formula is standard and used across all kinds of industries, whether big or small, product- or service-based.
The working capital turnover ratio is an important reflection of the company’s operations, management, and the company’s success. It also provides insights as to how well a company has been utilizing its working capital.
Usually, a higher company’s net sales to working capital ratio mean a more financially successful company (though an excessive amount of turnover has its own drawbacks). However, there are other insights too here which we will consider shortly.
The amount of working capital turnover that a company generates is a figure that is of significance to every business, but more for small businesses. This is a figure that accurately measures how efficient each dollar of working capital has been in earning revenue for the company or business and strengthening its financial situation.
Obviously, a high turnover ratio suggests a more efficient and profitable business. Similarly, a low ratio of the working capital turnover ratio indicates that your business operations are not all that successful and effective.
A company’s working capital turnover ratio is used to determine what its cash flow situation is and whether it can pay off its debts in a timely fashion or not in the near future.
Additionally, a low ratio of working capital turnover of a business may also indicate that there are too many accounts receivable and inventory used in supporting sales. In the future, this could lead to a condition of bad debts (loaned money that cannot be recovered) and inventory that is redundant and outdated.
Sometimes, financial analysts also compare a particular company’s working capital turnover ratio to the working capital turnover ratio of other companies that lie in the same industry and gather insights into how high or low this ratio is comparatively.
Working capital management is a term to explain the functions of keeping an eye on the cash flow situation and the current assets and current liabilities of a business. You usually end up with enough capital when your current assets are significantly greater than your current liabilities. It is used in future financial modeling of the business.
We have already seen that the total company’s sales when divided by the working capital, refers to the working capital turnover ratio. A high ratio of working capital turnover comes with many advantages. They are listed as follows:
A high working capital turnover ratio means the company has abundant cash to spare, which it can use to generate sales and for additional funding if needed. It also implies that its short-term debts are adequately covered and that its short-term assets are greater than its short-term liabilities.
A stable and high turnover ratio means there is abundant net working capital with the business that can be used in generating sales and writing off accounts payable. The strong fiscal health of the company will afford it that unique competitive edge in the market and enable it to run smoothly.
A high amount of average working capital will enhance the value of your company within its field of business. This will help it beat the competition and gain value and respect in the market.
An adequate amount of the company’s working capital means there is enough cash to support sales, increase gross sales and balance out the term assets and liabilities of the business. Hence a high net working capital is a strong indicator of all operations of the company running smoothly.
A high amount of net working capital in a company implies good, stable management, which will lead to higher net sales and more profits. It will also positively influence the company’s short-term assets.
Working capital turnover measures only the monetary or fiscal aspects of companies like net sales, the difference between term assets and liabilities, and related terms.
When analyzing the overall situation, the management of companies should also consider factors like recession, employee attrition due to low motivation levels, etc.
As much as the net working capital should be a robust, stable figure, an extremely high ratio of working capital turnover may imply that enough working capital is not available and more of it is needed to keep the company in the same situation as it is currently.
Business analysts who undertake working capital management for financial modeling usually keep this in mind.
So, if company A had an annual total sales volume of $200,000 in 2019 against an annual working capital of $40,000, its working capital turnover ratio is 200,000 divided by 40,000, yielding a ratio of 5:1 or 5. This effectively means that each dollar of working capital has yielded 5 dollars in return.