Working capital turnover is a ratio which measures how efficiently a company is using its working capital to support a given level of sales. Also referred to as net sales to working capital, it shows the relationship between the funds used to finance a company's operations and the revenues a company generates as a result.
The working capital turnover ratio is calculated by dividing net annual sales by the average amount of working capital – current assets minus current liabilities — during the same 12-month 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 turnover ratio shows that management is being very efficient in using a company’s short-term assets and liabilities for supporting sales, i.e., it is generating a higher dollar amount of sales for every dollar of the 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.
To manage how efficiently they use their working capital, companies use inventory management and manage 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 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 that a business does not have enough capital to support its sales growth. Therefore, the company could become insolvent in the near future. The indicator is especially strong when accounts payable is also very high, which indicates that the company is having difficulty paying its bills as they come due.