Working capital is an essential component of operating a small company. It is the amount of money that a company has left to spend on activities after paying off its bills and short-term debts. So, the working capital turnover ratio assesses how effectively a company uses its working capital to generate revenue. . A high ratio, in general, will help the company’s operations operate more smoothly and reduce the need for additional funding. In this article, we’ll learn more about the working capital turnover, formula, and some examples.
Calculation of Working Capital
According to Accounting Coach, working capital equals total current assets minus total current liabilities, all of which are on the balance sheet. Cash and other resources that you plan to use or convert to cash within a year, such as accounts receivable and inventory, are examples of current assets. Current liabilities are obligations that you plan to pay off in a year or less. They include accounts payable and short-term loans.
For example, if your small company has total current assets of $700,000 and total current liabilities of $500,000, your working capital is $200,000.
How does the Working Capital Turnover Ratio work?
The turnover ratio assesses how effectively a business uses its working capital to sustain a specified amount of revenue. Working capital is described as current assets less current liabilities. Hence, a high turnover ratio means that management is using a firm’s short-term assets and liabilities to fund revenue in an extremely efficient manner.
A low ratio, on the other hand, means that a company is investing in too many accounts receivable and inventory assets to finance its revenue. Thus, this could ultimately result in an excess of bad debts and redundant inventory write-offs.
Working Capital Turnover Formula
Divide net sales by working capital to get the ratio (which is current assets minus current liabilities). The measurement is typically done on an annual or trailing 12-month basis. Also, it takes into account the average working capital over that time period. The calculation is as follows:
((Beginning working capital + Ending working capital) / 2) Net sales
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Working Capital Turnover Ratio Example
ABC Company’s net revenues over the last twelve months totaled $12,000,000, with an average working capital of $2,000,000. Its turnover ratio is calculated as follows:
$2,000,000 in average working capital $12,000,000 in net sales
Working capital turnover ratio = 6.0
Working Capital Turnover Ratio Issues
An unusually high turnover ratio may mean that a business lacks sufficient capital to sustain its revenue growth; hence, the company’s demise could be imminent. This is an especially strong indicator when the accounts payable portion of working capital is very high, indicating that management is unable to pay the bills when they become due.
A high turnover ratio can be identified by comparing the ratio for a specific company to that published elsewhere in its industry to see if the business is showing outlier performance. This analogy is particularly useful when the benchmark companies have a similar capital structure.
Working Capital Turnover Ratio Synonyms
The working capital turnover ratio is also referred to as the net revenue to working capital ratio.
A working capital turnover ratio can give several benefits to a corporation. The following are the most important advantages of keeping track of your company’s turnover ratio:
- Ensures liquidity
- Improves financial stability in general
- Increases the worth of a business
- Ensures that operations are not disrupted.
- Increases profitability
#1. Ensures liquidity
When a company fails to maintain its working capital turnover ratio, it can run out of funds for day-to-day operations and incur short-term debts. Incorporating working capital management into your business strategy will help you keep on top of your company’s accounts payable, receivable, debt, and stock management. So, this means that you understand where your money is going and how to distribute it effectively for optimum management and productivity.
#2. Improves financial stability in general
In your company, using a working capital turnover ratio will help you better manage your cash outflow and evaluate your cash inflow. Being able to effectively decide how to use cash most profitably will improve the overall financial health of your business. It also helps to avoid running out of working capital and having to rely on external sources and incur debt. A higher average turnover ratio results in a higher return on capital employed. Thus, this can draw investors and increase the likelihood of the business expanding.
#3. Increases the worth of a business
A high working capital turnover ratio, including improved overall financial health, can boost a company’s overall value within its sector. So, this will help the company stand out among rivals, resulting in reputation and value addition.
#4. Ensures that operations are not disrupted.
Maintaining knowledge of your company’s turnover ratio will help avoid disruptions in your organization’s day-to-day activities by providing managers with information that allows them to use funds most effectively. Working capital used efficiently to maintain operations will reduce potential output stumbling blocks. Hence, it’ll keep the business as profitable as possible.
#5. Increases profitability
Over time, managing your company’s capital turnover can result in increased overall profitability. Your company can save money and use available cash more effectively by reducing or removing service interruptions and optimizing how they use the working capital.
While measuring your company’s working capital turnover ratio can provide some benefits, it’s important to remember that there are also potential drawbacks. When using working capital ratio turnover in your company’s financial analysis, the following issues can arise:
#1. Only considers monetary considerations
A working capital turnover ratio only considers a company’s monetary factors. While monetary considerations are important, non-monetary influences can also have an impact on a company’s financial health. For example, the working capital turnover ratio formula does not account for dissatisfied employees or recessionary periods, both of which can have an impact on a company’s financial health.
#2. A high ratio can be harmful.
A high turnover ratio may tend to be a good thing, but this is not always the case. It may indicate that a business does not have enough working capital to sustain its current sales growth. If the company’s working capital to revenue ratio is not adjusted, it will become insolvent in the future.
If you measure your company’s working capital turnover ratio and find it to be too high, you may need to assess your financial condition and make necessary changes to prevent bankruptcy.