Working capital turnover is a measurement comparing the depletion of working capital used to fund operations and purchase inventory, which is then converted into sales revenue for the company. The working capital turnover ratio is used to analyze the relationship between the money that funds operations and the sales generated from these operations. For example, a company with current assets of $10 million and current liabilities of $9 million has $1 million in working capital, which may be used in fundamental analysis.
The working capital turnover ratio measures how well a company is utilizing its working capital for supporting a given level of sales. Because working capital is current assets minus current liabilities, 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 contrast, a low ratio shows a business is investing in too many accounts receivable (AR) and inventory assets for supporting its sales. This may lead to an excessive amount of bad debts and obsolete inventory.
When calculating a company’s working capital turnover ratio, the amount of net sales is divided by the amount of working capital. The calculation is typically made on an annual or trailing 12-month basis and uses the average working capital during that time period. For example, Company A has $12 million of net sales over the past 12 months. The average working capital during that time was $2 million. The calculation of its working capital turnover ratio is $12,000,000/$2,000,000 = 6.
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 on a regular basis, 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.
However, an extremely high ratio, typically over 80%, may indicate a business does not have enough capital supporting its sales growth. Therefore, the company may become insolvent in the near future. The indicator is especially strong when the accounts payable (AP) component is very high, indicating that management cannot pay its bills as they come due. For example, gold mining and silver mining have average working capital turnover ratios of approximately 82%. Gold and silver mining requires ongoing capital investment for replacing, modernizing and expanding equipment and facilities, as well as finding new reserves. An excessively high turnover ratio may be discovered by comparing the ratio for a specific business to ratios reported by other companies in the industry.