Working Capital Turnover Ratio
Working Capital Turnover Ratio is a financial ratio which shows how efficiently a company is utilizing its working capital to generate revenue.
The Working Capital Turnover Ratio is also called Net Sales to Working Capital.
The ratio is very useful in understanding the health of a company.
To fully understand this ratio, first, we must fully understand Working Capital.
What is Working Capital?
Working Capital is the money available to a business AFTER it's fully paid off all its bills and short-term debts.
This money can then be utilized to expand the company operations and fund revenue growth.
It is calculated using the formula below:
Working Capital = Current Assets - Current Liabilities.
Both the Current Assets and Current Liability figures can be found in the Balance Sheet.
Example of a Working Capital calculation
If a business has $900,000 in current assets and $500,000 in current liabilities, its working capital would be $400,000.
Formula of Working Capital Turnover Ratio
Working Capital Turnover Ratio = Revenue/ Average Working Capital.
Average Working Capital equals working capital at the start of a period plus working capital at the end of the period divided by 2.
A higher ratio is better since it represents a better utilization of working capital.
A higher working capital turnover ratio also means that the operations of a company are running smoothly and there is a limited need for additional funding.
Example of the Working Capital Turnover Ratio
Let's say there are two competing businesses selling widgets - Superpower Inc. & Villan's Corp.
Both of them make the same amount of sales which is $1M a year. Additionally, Superpower Inc. has a working capital of $200,000, and Villans Corp. has a working capital of $500,000.
Which of these businesses is utilizing working capital more efficiently?
All else being the same, Superpower Inc. is generating Sales of $1M with a working capital of $200K, but it is taking Villian Corp. $500K to produce the same amount of sales.
Based on the formula above,
Working Capital Ratio for Superpower Inc. = $1M/200K = 5 times (5x)
Working Capital Ratio for Villian Corp = $1M/500K = 2 times (2x)
This means that Superpower Inc. is generating 5 times more sales for every dollar of working capital whereas Villian Corp is producing only 2 times more sales.
Can a companies Working Capital Turnover Ratio be negative?
Yes, a companies working capital ratio can be negative if a companies Working Capital is negative.
A companies working capital is negative when the companies current liabilities exceed its current assets.
Negative working capital is a giant red flag for a company as it means that the company is in financial trouble and management needs to act immediately to source additional funding.
To check out the many sources through which a company raises working capital check out our article here.
What is the best way to use the Working Capital Turnover Ratio?
There are two ways to best make use of the Working Capital Turnover Ratio.
The first is to compare the calculated ratio with the companies own historical records to spot trends. A stable ratio means that money is flowing in and out of the business smoothly. However, an increasing or declining trend needs further analysis.
Secondly, this ratio is extremely useful as a benchmark when compared with its competitors since these companies sell similar products. A high Working Capital Turnover ratio is a significant competitive advantage for a company in any industry.
Test your knowledge of the Working Capital Turnover Ratio by taking the quiz below.
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