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 ahead. One important metric is the working capital turnover ratio.
This article will highlight how monitoring the working capital turnover ratio regularly helps you identify signs of potential liquidity risks ahead of time. It will discuss ways you can interpret trends in the ratio and use them to make informed financial decisions for your business.
What does the working capital turnover ratio mean?
The working capital turnover ratio provides insights into a company's working capital management and liquidity position. It belongs to the class of liquidity ratios used for financial ratio analysis to assess the short-term health of a business.
The working capital turnover ratio refers to a company's current assets minus current liabilities. It indicates the operating liquidity available to manage daily business activities and meet upcoming financial obligations.
A higher ratio means the company is more liquid, has a better cushion for day-to-day functioning, and can expand and grow its operations. A lower ratio indicates potential issues in meeting upcoming financial obligations due to cash flow problems.
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
Where:
Net Annual Credit Sales = Total Annual Sales - Cash Sales - Sales Returns and Allowances
Average Working Capital = (Beginning Working Capital + Ending Working Capital)/2
Working capital turnover can also be calculated as:
Working Capital Turnover Ratio = Net Sales / Average Working Capital
Where net sales are total sales minus discounts, returns and allowances.
Using average working capital smoothens fluctuations and gives a more accurate picture than point-in-time 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:
#1. A ratio under 2 means inefficient use of working capital to generate sales. There is an opportunity to improve.
#2. A ratio between 3 to 5 is deemed good for most industries. It indicates sufficient sales being produced from working capital.
#3. 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.
Wrapping up
The working capital turnover ratio offers simple but powerful insights for companies to manage their working capital better. It complements other liquidity metrics to provide a comprehensive view of operational efficiency.
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.
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17 January 2024
5 mins read
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