Delving into Working Capital Turnover Ratio: A Comprehensive Guide
The Working Capital Turnover Ratio is a financial metric that assesses a company’s efficiency in using its working capital to generate sales revenue. This ratio helps businesses understand how effectively they’re leveraging their capital to drive sales and operate efficiently. Let’s dive into a comprehensive explanation of this crucial financial metric.
The Working Capital Turnover Ratio, also known as inventory turnover ratio. It shows how good a company is at using its money to make sales. It’s like seeing how well a lemonade stand uses its lemons and sugar to sell lemonade.
Why it matters?
Working capital is like the money a company needs to keep its doors open and run its day-to-day business. It’s the difference between what the company has on hand (current assets) and what it owes to others (current liabilities).
- It measures how efficiently a company utilizes its working capital to generate sales over a specific period.
- It evaluates the company’s ability to convert working capital into revenue.
- It represents the number of times a company’s working capital is turned into revenue during a specific period, typically a fiscal year.
- It measures how well all the money is used for sales.
- It focuses on how well the money for daily operations makes sales.
Formula and Calculation
It’s calculated by dividing net sales by average working capital.
Formula:
Working Capital Turnover Ratio = Net Sales / Average Working Capital
Calculation:
To calculate the working capital turnover ratio, follow these steps:
- Determine Net Sales: Net sales refer to a company’s total revenue after deducting returns, discounts, and allowances.
- Calculate Average Working Capital: Average working capital is the average of the beginning and ending working capital balances for the period. Working capital is calculated by subtracting current liabilities from current assets.
Types of Working Capital Turnover Ratio
Inventory Turnover Ratio: This ratio specifically measures how quickly a company sells its inventory, indicating its efficiency in managing inventory levels.
1. Operating Working Capital Turnover Ratio: Focuses on operational efficiency by considering operating working capital
Formula: Net Sales / Operating Working Capital
2. Total Working Capital Turnover Ratio: Measures overall efficiency in using total working capital
Formula: Net Sales / Total Working Capital
3. Inventory Turnover Ratio = This ratio specifically measures how quickly a company sells its inventory, indicating its efficiency in managing inventory levels.
Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
4. Account Receivable Turnover Ratio: This ratio assesses a company’s efficiency in collecting payments from its customers.
Formula: Account Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
5. Days Sales Outstanding (DSO): DSO represents the average number of days it takes a company to collect payment from its customers. It is calculated as the inverse of the account receivable turnover ratio.
Formula: Days Sales Outstanding = 365 / Account Receivable Turnover Ratio
Interpretation and Benchmarks
A higher working capital turnover ratio generally indicates that a company is efficiently utilizing its working capital, generating more sales per dollar invested in working capital.
Higher Is Better: A higher number means the money is used well to make more sales.
However, it is important to consider industry benchmarks, as different industries have varying working capital requirements.
- Efficiency Benchmark: Helps gauge how effectively a company manages its working capital resources.
- Higher Ratio Significance: A higher ratio indicates better utilization of working capital to generate sales revenue, showcasing efficient operations.
- Industry Comparison: Comparing this ratio to industry benchmarks provides insights into relative efficiency.
Benefits of Working Capital Turnover Ratio
- Identifying Efficiency: The working capital turnover ratio helps identify areas where a company can improve its efficiency, such as reducing inventory levels or accelerating collections.
- Evaluating Cash Flow: A strong working capital turnover ratio suggests that a company is generating cash efficiently, which can improve its liquidity and overall financial health.
- Making Informed Decisions: Investors and analysts use the working capital turnover ratio to assess a company’s financial performance and make informed investment decisions.
Questions and Answers: Total Working Capital Turnover Ratio Examples
Example 1
| Date | Current Assets | Current Liabilities | Working Capital |
|—|—|—|—|
| 2022-01-01 | 100000 | 80000 | 20000 |
| 2022-01-31 | 120000 | 90000 | 30000 |
| 2022-02-28 | 130000 | 100000 | 30000 |
| 2022-03-31 | 140000 | 110000 | 30000 |
| 2022-04-30 | 150000 | 120000 | 30000 |
| 2022-05-31 | 160000 | 130000 | 30000 |
| 2022-06-30 | 170000 | 140000 | 30000 |
| 2022-07-31 | 180000 | 150000 | 30000 |
| 2022-08-31 | 190000 | 160000 | 30000 |
| 2022-09-30 | 200000 | 170000 | 30000 |
| 2022-10-31 | 210000 | 180000 | 30000 |
| 2022-11-30 | 220000 | 190000 | 30000 |
Average Working Capital = (20000 + 30000 + 30000 + … + 30000) / 12 = 30000
Net Sales = 2000000 (Assuming annual net sales of $2,000,000)
Working Capital Turnover Ratio = Net Sales / Average Working Capital = 2000000 / 30000 = 6
In this example, the working capital turnover ratio is 68.57. This means that the company is generating $68.57 of sales for every $1.00 of working capital. This is a good indication that the company is efficiently managing its working capital.
Example 2: Total Working Capital Turnover Ratio Example:
Suppose a company has net sales of $500,000 and total working capital of $100,000:
Total Working Capital Turnover Ratio= (500,000/100,000)=5
This means the company generates $5 of sales revenue for every $1 of total working capital.
Example 3: Operating Working Capital Turnover Ratio Example:
If the same company’s operating working capital is $80,000:
Operating Working Capital Turnover Ratio= (500,000/80,000)=6.25
This implies the company generates $6.25 of sales revenue for every $1 of operating working capital.
Conclusion
The working capital turnover ratio serves as a valuable tool for understanding a company’s ability to manage its working capital effectively. By analyzing this ratio and comparing it to industry benchmarks, investors and analysts can gain insights into a company’s operational efficiency and financial health.
Photo credit: stevepb via Pixabay
