Working capital turnover ratio is a financial metric that measures how much revenue a business can generate using its working capital. It is an essential indicator of a company’s operational efficiency, liquidity, and solvency. The working capital turnover ratio formula can be used to evaluate a business’s ability to use its working capital to generate sales. Working capital finance is critical to every business operation. Therefore, business owners need to have a good grasp of this metric. In this article, we will explain how to calculate your working capital turnover ratio and what it means for your business.
What Is Working Capital Turnover Ratio?
Working capital turnover ratio is the ratio between net sales and working capital. Net sales are the total sales a business generates minus any returns or discounts. In contrast, working capital is the difference between current assets and current liabilities. It is the money available for the business to pay bills, wages, and procure raw materials. When you divide net sales by working capital, you get the working capital turnover ratio.
The working capital turnover ratio shows the number of times that a company’s working capital is turned over during a specific period. In other words, it shows how efficiently the company is using its working capital to generate revenue. A high working capital turnover ratio implies that the business is efficient in utilizing its working capital to generate revenue. It also suggests that the company has a short cash-to-cash cycle.
On the other hand, a low working capital turnover ratio indicates that the business struggles to generate sales with its available working capital. It implies that the company may have a long cash-to-cash cycle, which means that it takes too long to convert raw materials into cash. A low working capital turnover ratio may signal inadequate management of working capital, which may lead to cash flow problems in the future.
How to Calculate Your Working Capital Turnover Ratio?
To calculate the working capital turnover ratio, you will need to gather two sets of financial data: net sales and working capital. You can obtain both data from your financial statements.
First, find the net sales figure for the period you want to evaluate. You can find this figure on your income statement or profit and loss statement. The net sales figure is your total sales minus any deductions such as returns, discounts, and allowances. You should use the net sales figure instead of the gross sales figure because it reflects the sales that actually generate revenue for your business.
Next, calculate your working capital figure. Working capital is the difference between current assets and current liabilities. You can find both figures on your balance sheet. Current assets include cash, accounts receivable, inventory, and prepaid expenses. Current liabilities include accounts payable, accrued expenses, and short-term debt. Subtract the current liabilities from the current assets to get your working capital figure.
Once You Have Both Figures, Divide The Net Sales Figure By The Working Capital Figure:
Working capital turnover ratio = Net sales ÷ Working capital
For example, if your business generated Rs. 500,000 in net sales over the year and had Rs. 150,000 in working capital, your working capital turnover ratio would be:
Working capital turnover ratio = Rs. 500,000 ÷ Rs. 150,000
= 3.33
This means that your company generated Rs. 3.33 of sales for every dollar of working capital available during that period.
What Your Working Capital Turnover Ratio Tells You
The working capital turnover ratio indicates how efficiently your business utilizes its working capital to generate revenue. Typically, a higher ratio indicates a better operational efficiency of the business because it is generating more revenue with each unit of its working capital. On the other hand, a lower ratio indicates that your business is not making the most of its available working capital.
Your working capital turnover ratio may vary depending on your industry, size of the business, and specific market conditions. Therefore, it is essential to compare your ratio to your competitors or industry averages to gain a better understanding of how your business performs.
Advantages of a High Working Capital Turnover Ratio
A high working capital turnover ratio brings several benefits to your business. It indicates that your business can generate revenue more efficiently while using fewer resources and working capital. Some of the advantages of a high working capital turnover ratio include:
– Improves cash flow: A high working capital turnover ratio means that your business can generate cash faster, improving your cash flow position.
– Increases profitability: When you can generate more sales with less investment, you can increase your business’s profitability.
– Boosts investor confidence: A high working capital turnover ratio indicates that your business is financially stable and capable of generating revenue, which can boost investor confidence.
Disadvantages of a Low Working Capital Turnover Ratio
A low working capital turnover ratio may signal cash flow issues, underutilized resources, or an inefficient business operation. It can lead to several disadvantages, including:
– Poor liquidity: A low working capital turnover ratio may mean that your business has excess inventory or uncollectable debts, which can affect your liquidity.
– Low profitability: When your business cannot generate sales with its available working capital, it may reduce profitability.
– Lack of investor confidence: A low working capital turnover ratio may indicate financial instability, which can reduce investor confidence.
Conclusion
Working capital turnover ratio measures operational efficiency, liquidity, and solvency. It tells you how many times your business can convert its working capital into revenue during a specific period. A high working capital turnover ratio is ideal as it indicates that your business can generate more sales with less investment. On the other hand, a low working capital turnover ratio may signal issues such as poor liquidity, low profitability, and lack of investor confidence.
Calculating your working capital turnover ratio is easy. Simply divide your net sales by your working capital figure. It is essential to compare your ratio to your industry average to determine how your business performs. By measuring and managing your working capital turnover ratio, you can improve your cash flow, profitability and achieve better financial stability.
