As business owners, you must be aware that if a company’s working capital turnover ratio is not monitored regularly, there might be disruptions in cash flow for day-to-day operations. Analysing this financial metric would help you reduce production bottlenecks and keep the business profitable.
Read on to know more.
What is working capital turnover ratio?
Working capital turnover ratio is a financial metric that helps business owners understand how well their company is using its working capital to generate sales. It’s calculated by dividing net sales by average working capital. Higher turnover implies better efficiency in using working capital to support sales.
Working capital turnover ratio formula
The formula for calculating the working capital turnover ratio is:
Working Capital Turnover Ratio =Net Sales / Average Working Capital
– Net Sales refers to the total sales after deducting sales returns, discounts, and allowances.
– Average Working Capital is the average of the current assets minus the current liabilities over a specific period.
Average Working Capital = Beginning Working Capital + Ending Working Capital / 2
Beginning working capital is the amount of working capital available at the beginning of the accounting period. It’s calculated by subtracting current liabilities from current assets at the start of the period.
Ending working capital is the amount of working capital available at the end of the accounting period. It’s calculated by subtracting current liabilities from current assets at the end of the period.
Example of working capital turnover ratio
Let’s consider an example of ABC Pvt. Ltd., to explain working capital turnover ratio.
ABC Pvt. Ltd. has the following details for a given year:
– Net sales: Rs. 5,000,000
– Beginning working capital: Rs. 800,000
– Ending working capital: Rs. 600,000
Here’s how you calculate working capital turnover ratio:
Step 1: Calculate the average working capital.
Average Working Capital = Beginning Working Capital + Ending Working Capital / 2
= 800,000 + 600,000 / 2
= 1,400,000 / 2
= Rs. 700,000
Step 2: Use the working capital turnover ratio formula.
Working Capital Turnover Ratio =Net Sales / Average Working Capital
= 5,000,000 / 700,000
= 7.14
Therefore, ABC Pvt. Ltd. has a working capital turnover ratio of 7.14 for that particular year. This means the company generates Rs. 7.14 in sales for every Rs. 1 of average working capital employed during the year.
Interpreting working capital turnover ratio
High working capital turnover ratio: When the working capital turnover ratio is high, it indicates that cash is flowing in and out of your business seamlessly and is working in your favour. However, an excessively high ratio might imply aggressive management of working capital, potentially leading to stock outs or supply chain issues.
Also read: Top 4 disadvantages of excessive working capital for SMEs
Low working capital turnover ratio: If your working capital turnover ratio is low, it indicates that you’re spending too much on inventory and accounts receivable for sales. It might lead to bad debt and obsolete inventory.
Comparing the working capital turnover ratio with industry benchmarks and trends over time for the specific company provides a clearer understanding of its efficiency. There’s no fixed universal benchmark for a “good” ratio, but a consistently improving or healthy ratio concerning industry norms is generally favourable.
Special considerations in working capital management
Working capital management and working capital turnover ratio are interrelated aspects of a company’s financial operations.
– Working capital management: It involves overseeing the components of working capital, like current assets and current liabilities, to ensure the company maintains an optimal balance. Efficient management aims to have enough resources to cover short-term operational needs while avoiding over-investment in non-productive assets.
– Working capital turnover ratio: This ratio assesses how effectively a company utilises its working capital to generate sales. It measures the efficiency of this capital in supporting revenue generation.
The relationship between them lies in the cause-and-effect dynamic:
1. Efficient management and ratio improvement: Improved working capital management, such as reducing inventory levels or optimising accounts receivable, tends to increase the turnover ratio. By using working capital more efficiently, the company generates more sales per unit of capital employed.
2. Influence on decision-making: Monitoring the turnover ratio aids in decision-making regarding the management of working capital. For instance, a decreasing turnover ratio might signal inefficient use of working capital, prompting a reassessment of the company’s management strategies to enhance efficiency.
3. Feedback loop: The turnover ratio reflects the effectiveness of working capital management strategies. It provides insights into how well the company converts working capital into revenue. Subsequently, it guides adjustments in working capital management practices to enhance the ratio.
In essence, efficient working capital management often leads to a higher turnover ratio. Monitoring and adjusting both components are crucial for maintaining optimal financial health and operational efficiency within a company.
Can working capital turnover ratio be negative?
Working capital turnover ratio is a measure of how effectively a company utilises its working capital to generate sales. In theory, this ratio can technically be negative, but it’s an unusual scenario and not a common or preferred situation.
A negative working capital turnover ratio might occur under certain circumstances such as:
- Significant fluctuations in sales: If the company experiences a sharp decline in sales while maintaining a relatively constant or increasing level of working capital, it can result in a negative turnover ratio. This indicates that the capital is not being effectively used to generate sales.
- Inaccurate data or calculations: Errors in financial data or calculations could potentially lead to an anomalous negative ratio, though these instances are generally rectifiable through careful review and correction of the data.
- Specific industry dynamics: In industries with irregular sales cycles or significant seasonal fluctuations, there might be periods where the ratio temporarily appears negative due to the mismatch between sales and working capital.
Is working capital turnover ratio a profitability ratio?
No, the working capital turnover ratio is not a profitability ratio. Instead, it’s an efficiency or activity ratio that measures how effectively a company utilises its working capital to generate sales. It assesses the relationship between the working capital and the sales revenue generated, focusing on operational efficiency rather than overall profitability. Profitability ratios, on the other hand, analyse the company’s earnings in relation to its sales, assets, or equity to determine its overall profitability.
Advantages of working capital turnover ratio
- Efficiency assessment: It provides insights into how effectively a company utilises its working capital to generate sales, offering a measure of operational efficiency.
- Comparative analysis: Facilitates comparisons within the industry or over time, helping in benchmarking and identifying trends in efficiency improvements or declines.
- Decision making: Helps in decision-making processes related to working capital management, such as inventory control, accounts receivable, and payable management.
- Identifying operational health: Offers a snapshot of the health of day-to-day operations, enabling a better understanding of the company’s financial health.
Limitations of working capital turnover ratio
- Limited information: It provides a narrow view of efficiency and doesn’t encompass other aspects of financial health or overall profitability.
- Industry variations: Comparing turnover ratios across different industries might not be accurate due to different business models and operational requirements.
- Data precision: Relying solely on this ratio might overlook nuances in the data, leading to misleading interpretations.
- Temporal fluctuations: Variability in sales or working capital components during specific periods can distort the ratio’s accuracy and make it less reliable for certain analyses.
If you’ve been wondering about how best to use the working capital turnover ratio to effectively incorporate it into decision-making for your business, here are a few tips:
– Use this financial metric to check the efficiency of your business. Make new strategies based on the findings.
– Identify trends and compare the performances of most companies in the same sector. Then, make investment-related decisions accordingly.
Key takeaway
To sum up, working capital turnover ratio is an important financial metric that helps you understand whether your company is using its working capital in an effective way or not. While a high turnover ratio lends you an edge against your competitors, it may not always be accurate. On the other hand, a low ratio may indicate that your company is heading towards bad debt. It’s highly recommended that you keep regular track of your working capital turnover ratio to maintain the financial health of your business.
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