Managing finances effectively is vital for companies to maintain liquidity and spur growth. As business leaders, you need metrics to gain foresight into potential risks. One important metric is the working capital turnover ratio. It measures how efficiently a company uses its working capital to generate sales. A higher ratio indicates better short-term asset management. This article describes what is working capital turnover ratio, its calculation, advantages and limitations. We also discuss ways you can interpret trends in the ratio and use them to make informed financial decisions for your business.
How to calculate working capital turnover?
To calculate the working capital turnover ratio, follow the steps given here:
Step 1: Calculate the average working capital
Calculate working capital by subtracting your company’s liabilities from its assets.
Working Capital=Assets-Liabilities
The average working capital is the average of the working capital over a specified period.
The formula for average working capital is:
Average Working Capital = (Beginning Working Capital + Ending Working Capital) / 2
Beginning working capital is working capital available at the beginning of the accounting period, and ending working capital is available at the end.
Step 2: Calculate the net sales
Net sales are the difference between total sales minus the sales returns, discounts and allowances. The formula can be written as:
Net sales=Total Sales-Sales Returns-Discounts-Allowances
Step 3: Use the Working Capital Turnover Formula
The formula is discussed in the next section.
Working capital turnover ratio formula
Here is the formula to calculate the working capital turnover ratio:
Working Capital Turnover Ratio = Net Annual Credit Sales / Average Working Capital
Here is an example of working capital turnover ratio:
For the year, if a company reported:
Total Sales: INR 500,000
Cash Sales: INR 100,000
Sales Returns: INR 5,000
Beginning Working Capital: INR 80,000
Ending Working Capital: INR 90,000
Net Credit Sales = Total Sales – Cash Sales – Returns = INR 500,000 – INR 100,000 – INR 5,000 = INR 395,000
Average Working Capital = (Beginning + Ending) / 2 = (INR 80,000 + INR 90,000) / 2 = INR 85,000
Working Capital Turnover Ratio = Net Credit Sales / Average Working Capital = INR 395,000 / INR 85,000 = 4.65
What is a good working capital turnover ratio?
The optimal working capital turnover ratio varies widely by industry.
Industries like retail and grocery stores that make cash sales and operate on thinner margins tend to have higher ratios. Due to significant investments, capital-intensive sectors like oil and gas operate with lower ratios.
As a rule of thumb:
- A ratio under 2 means inefficient use of working capital to generate sales. There is an opportunity to improve.
- A ratio between 3 to 5 is deemed good for most industries. It indicates sufficient sales being produced from working capital.
- A ratio over 7-8 may indicate overtrading, that is, the risk of insufficient working capital to sustain projected sales growth.
Comparing the ratio to industry benchmarks provides a more meaningful assessment. The focus should be on improving one’s ratio year-over-year rather than chasing high numbers.
Working capital management strategies
Working capital turnover ratios enable companies to identify potential areas of working capital management for better efficiency. Here are some strategies:
1. Inventory turnover ratio
This ratio reflects how often inventory is sold and replaced in a period. A low inventory turnover implies excessive inventory levels than needed to support sales. Strategies to improve inventory management include demand forecasting, lean manufacturing and drop shipping.
Utilise sophisticated forecasting tools and data analytics to accurately predict demand. This helps in aligning inventory levels with actual market needs. Collaborate closely with suppliers to establish flexible supply agreements that allow quick adjustments based on demand fluctuations.
2. Receivables turnover ratio
This indicates the number of times accounts receivables are collected in a period. A lower ratio suggests more lenient credit terms or delays in collecting dues from customers. Tighter credit policies, invoice factoring and credit insurance help optimise receivables.
Review and tighten credit policies to ensure that terms are clear and credit limits are set judiciously to optimise the receivables turnover ratio. Implement efficient invoicing systems to reduce billing errors and ensure timely and accurate invoices.
Additionally, encourage customers to pay early by offering discounts, thereby improving the receivables turnover ratio.
3. The payables turnover ratio
This ratio measures how frequently a company pays off its creditors. An excessively high ratio indicates the company may be defaulting on payments to suppliers. Negotiating favourable payment terms and maintaining strong supplier relationships are key.
Also, work collaboratively with suppliers to find mutually beneficial, profitable solutions for both parties’ working capital.
4. The operating cycle
This is the period between purchasing inventory and collecting cash from sales. Minimising the operating cycle improves the working capital. Strategies include negotiating better credit terms, reducing inventory days and accelerating collections.
Evaluate and streamline internal processes to lessen the time to convert inventory into cash. To accelerate cash collection, implement efficient collection processes, such as automated reminders for overdue payments.
Advantages of Working Capital Turnover Ratio
- Efficiency Assessment: The working capital turnover ratio is the main indicator of a company’s efficiency. It determines how efficiently a company uses its capital to generate sales.
- Comparative Analysis: This metric also enables businesses to compare their performance within the industry and across periods. It provides trends such as the variation in the utilization of working capital.
- Informed Decision-Making: The working capital turnover ratio enables a business to make informed decisions regarding working capital utilization management and its various aspects.
Limitations of Working Capital Turnover Ratio
- Limited Scope: The working capital turnover ratio takes a narrow outlook on operational efficiency and ignores other aspects, such as financial health and overall profitability.
- Industry Differences: Business models vary across different industries. Hence, comparing the working capital turnover ratio among businesses in different industries can be misleading.
- Data Precision: Relying on this single ratio can lead to overlooking crucial underlying data that can give meaningful results and predictions.
Conclusion
We hope now you understand the working capital turnover ratio meaning. The working capital turnover ratio offers simple but powerful insights for companies to manage their working capital better. Driving this ratio higher can directly boost sales productivity and free up capital for growth initiatives. However, chasing high turnover without considering profitability impacts can be counterproductive. As with all financial ratios, trends matter more than absolute numbers. Regular monitoring of working capital turnover ratios, benchmarking against peers, and ratio analysis of individual components like receivables, inventory, and payables are crucial.
FAQs
Yes, the working capital turnover ratio can be negative. This happens when a company has more liabilities than assets. It results in a negative working capital.
No, the working capital turnover ratio is not a profitability ratio. It measures operational efficiency and determines how well a business uses its working capital to generate sales.
The optimal working capital turnover ratio varies widely by industry. Hence, there is no normal working capital turnover ratio. Generally, a higher working capital turnover ratio is considered better.
An increase in the working capital turnover ratio is considered good in general. It indicates that a business is becoming more efficient in utilizing its working capital to generate sales.
Another name for the working capital turnover ratio is the current ratio because the working capital turnover ratio considers the current assets and liabilities of a business.
25 April 2025
6 mins read
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