Working Capital Turnover Ratio indicates a company’s efficiency in using its available working capital and displays the relationship between its funds and revenues. Here is how to calculate the working capital turnover ratio, its advantages, and how to calculate it.
If you want to measure how efficiently your company performs and makes money, you can get a data-based idea by calculating its working capital turnover rate. It is a vital metric that analyses how effectively your organisation converts your cash into sales. Calculating this ratio helps you determine the liquidity state of your company and adequately optimise the operations.
In this article, we will explain what a net working capital turnover ratio is, the formula to calculate it, and discuss its advantages with an example.
What is Working Capital Turnover Ratio?
A working capital turnover ratio is a parameter to calculate how efficiently an organisation generates sales using its net working capital. In this variable, net working capital refers to a company’s operating cash that it uses to conduct its day-to-day operations. Another crucial metric in this aspect is the net sales to working capital.
A working capital turnover ratio holds great importance for businesses, especially for small-sized enterprises. It accurately presents an idea of the funds available for everyday operations after fulfilling debt payments and other financial obligations. A company with a higher turnover ratio demonstrates higher efficiency in generating sales and conducting regular operations. On the other hand, a lower turnover ratio indicates opportunities for improvement. Companies commonly use this ratio to determine their financial performance and analyse their overall operations. Based on this parameter, company owners also decide whether they can pay off their debt before the due date without running out of cash due to high production requirements.
Calculating Working Capital Turnover Ratio
The working capital turnover formula contains two crucial elements: net sales and working capital. You can calculate the net sales by subtracting customer returns from your company’s gross sales during a period. Some analysts also use the COGS (Cost of Selling Goods) instead of net sales to calculate their working capital turnover ratio. Some believe the COGS is more directly related to a company’s efficient use of the working capital.
Therefore, the working capital turnover ratio formula is as follows:
Working Capital Turnover Ratio = Net Annual Sales / Working Capital
The formula to calculate the working capital is:
Working Capital = Current Assets - Current Liabilities
Or
Working Capital Turnover Ratio = COGS / Working Capital
Where, COGS = Net Sales – Gross Profit
And, COGS = Opening Stock + Purchases – Closing Stock
Company owners can derive the information related to their average working capital from their closing or beginning balance sheets.
Also, Read: Working Capital Cycle: Meaning, Calculation & More
How to Calculate Working Capital Turnover Ratio?
Now that you know the working capital turnover formula, here is a stepwise process to calculate the working capital turnover ratio:
- Calculate Working Capital
You can calculate your company's working capital by subtracting your current liabilities from current assets. For instance, if your company has current assets worth Rs 1 Crore and your current liabilities are Rs 20 Lakh, your working capital would be Rs 80 Lakh. The formula to calculate the working capital is:
Working capital = current assets - current liabilities
- Apply the Working Capital Turnover Ratio Formula
Now that you have your working capital figure, the next step is to apply the working capital turnover formula. It is:
Working capital turnover ratio = net annual sales/working capital
Using the above example, if your company's net annual sales are Rs 1.2 Crore, you must divide it by your working capital, which is Rs 80 Lakh. The calculation using the formula yields a working capital turnover ratio of 1.5.
A working capital turnover ratio below one indicates potential liquidity problems in the future. Companies with a low turnover ratio must evaluate their operations to find more cost-efficient operational solutions. On the other hand, a ratio of 1.5 to 2 indicates sufficient liquidity, helping an organisation understand the areas of economic success.
- Implications of a High Working Capital Turnover Ratio
A high ratio indicates that a company is efficiently using its short-term assets and liabilities to generate sales. That means your company generates a higher sales amount for every rupee employed. Eventually, it indicates smooth business operations with money moving in and out regularly, allowing you to invest in inventories and business expansion with a competitive advantage. However, an exceptionally high turnover ratio suggests a lack of capital to support sales growth.
- Implications of a Low Working Capital Turnover Ratio
A low working capital turnover indicates unnecessary investments in inventory and accounts receivable to support sales, resulting in a higher number of obsolete inventory and bad debts.
Read Also: What is Working Capital Management? | Definition & How to Calculate
Advantages of Using a Working Capital Turnover Ratio
Calculating the working capital turnover ratio is beneficial for maintaining sufficient cash flow for regular operations and loans. It makes working capital turnover management more efficient and helps you stay on top of your company’s accounts payables and receivables, stock management, debt management, etc. Moreover, it minimises disruptions in everyday operations by providing information about cash management. Simply put, it enables you to efficiently utilise your working capital for operational management and efficiency. As a company owner, you can efficiently use working capital to maintain business operations, reduce production bottlenecks, and generate maximum profits.
Conclusion
Generally, a higher working capital turnover ratio is beneficial, while a low ratio signifies inefficient use of the available working capital. Calculate the ratio carefully to utilise the company’s working capital efficiently and explore available sources of business finance.
FAQ:
- What is the best capital turnover ratio?
A working capital turnover ratio between 1 and 2 is the best figure that indicates efficient use of the available working capital while making accounts payables and receivables adequately.
- What if the working capital turnover ratio is negative?
A working capital turnover ratio of below 1 is negative. It indicates liquidity problems in the future and demands determining more cost-efficient operational solutions.
- What working capital ratio is too high?
A working capital turnover ratio of above two is not necessarily a better number. It indicates that the company needs to employ its assets more adequately to generate the maximum revenue attainable.
- What if the working capital ratio is more than 2?
If your working capital turnover ratio is more than two, it suggests you are not making optimum use of your available working capital. When that happens, consider raising additional capital to boost the chances of future growth.
