What Is Working Capital Turnover?
Working capital turnover is a ratio that measures how efficiently a company is using its working capital to support sales and growth. Also known as net sales to working capital, working capital turnover measures the relationship between the funds used to finance a company's operations and the revenues a company generates to continue operations and turn a profit.
- Working capital turnover measures how effective a business is at generating sales for every dollar of working capital put to use.
- A higher working capital turnover ratio is better, and indicates that a company is able to generate a larger amount of sales.
- However, if working capital turnover rises too high, it could suggest that a company needs to raise additional capital to support future growth.
Working Capital Turnover
The Formula for Working Capital Turnover Is
Working Capital Turnover=Average Working CapitalNet Annual Sales
- net annual sales is the sum of a company's gross sales minus its returns, allowances, and discounts over the course of a year
- average working capital is average current assets less average current liabilities
What Does Working Capital Turnover Tell You?
A high turnover ratio shows that management is being very efficient in using a company’s short-term assets and liabilities for supporting sales. In other words, it is generating a higher dollar amount of sales for every dollar of working capital used.
In contrast, a low ratio may indicate that a business is investing in too many accounts receivable and inventory to support its sales, which could lead to an excessive amount of bad debts or obsolete inventory.
To gauge just how efficient a company is at using its working capital, analysts also compare working capital ratios to those of other companies in the same industry and look at how the ratio has been changing over time. However, such comparisons are meaningless when working capital turns negative because the working capital turnover ratio then also turns negative.
Working Capital Management
Working capital management commonly involves monitoring cash flow, current assets, and current liabilities through ratio analysis of the key elements of operating expenses, including working capital turnover, the collection ratio, and inventory turnover ratio.
Working capital management helps maintain the smooth operation of the net operating cycle, also known as the cash conversion cycle (CCC)—the minimum amount of time required to convert net current assets and liabilities into cash. When a company does not have enough working capital to cover its obligations, financial insolvency can result and lead to legal troubles, liquidation of assets, and potential bankruptcy.
To manage how efficiently they use their working capital, companies use inventory management and keep close tabs on accounts receivables and accounts payable. Inventory turnover shows how many times a company has sold and replaced inventory during a period, and the receivable turnover ratio shows how effectively it extends credit and collects debts on that credit.
A high working capital turnover ratio shows a company is running smoothly and has limited need for additional funding. Money is coming in and flowing out regularly, giving the business flexibility to spend capital on expansion or inventory. A high ratio may also give the business a competitive edge over similar companies as a measure of profitability.
However, an extremely high ratio might indicate that a business does not have enough capital to support its sales growth. Therefore, the company could become insolvent in the near future unless it raises additional capital to support that growth.
The working capital turnover indicator may also be misleading when a firm's accounts payable are very high, which could indicate that the company is having difficulty paying its bills as they come due.
Example of Working Capital Turnover
Say that Company A has $12 million in net sales over the previous 12 months. The average working capital during that period was $2 million. The working capital turnover ratio is thus $12,000,000 / $2,000,000 = 6.0. This means that every dollar of working capital produces $6 in revenue.