Walter Harvey Pvt Ltd had spent ₹12,00,000 to run its day-to-day operations, such as inventory management, transportation of raw material, and so on. This means they had a working capital of ₹12,00,000. It had ₹60,00,000 in net sales over the last 12 months.
But how do they determine if they’ve used their resources effectively?
This is when the working capital turnover ratio helps! Thus, their working capital turnover ratio is ₹60,00,000/₹12,00,000 = 5.0. This means that every ₹1 of working capital produced ₹5 in revenue.
This article talks about the working capital turnover ratio and what it conveys.
What does it actually mean?
To understand the working capital turnover ratio, you must know about working capital.
Working capital is the difference between the current assets and the current liabilities of a company. This difference, when computed, measures the company’s liquidity, operational efficiency, and financial health in the near future (short-term).
If the company has considerable positive working capital, it most likely has sufficient funds to invest and grow. But if its working capital is negative (or low), then it may face troubles in its growth and settling its debts. Eventually, it might go bankrupt. Although positive working capital is good, it sometimes suggests that the company has excess inventory or has not invested excess cash.
Now, coming to the working capital turnover ratio…
The working capital turnover ratio estimates how efficiently a company utilizes its working capital to grow its sales. Since it is the ratio between the net sales and the average working capital, it is also called net sales-to-working capital.
In other words, the working capital turnover ratio assesses the relationship between the funds used to run the operations of a company and the revenues it is earning to keep running its further day-to-day operations and remain profitable.
Working capital turnover ratio formula
The working capital turnover ratio can be calculated by dividing the average working capital by the net annual sales. So, the working capital turnover formula is
Working Capital Turnover Ratio = Net Annual Sales/Average Working Capital.
In the formula, the net annual sales are the sum of a company’s gross sales in a particular period, deducted by its returns, allowances, and discounts. In contrast, average working capital is the difference between average current assets and average current liabilities.
Example of working capital turnover ratio
Assume that you own an art supplies store. You sell products for art students, professional artists, art hobbyists, and art colleges.
In the course of the year, you made sales of ₹36,00,000. Moreover, your working capital was ₹7,00,000.
You wonder if you’ve used your resources to their best or not. Therefore, you computed your store’s working capital turnover ratio to determine this.
To calculate it, you divided your net sales (₹36,00,000) by your average working capital (₹7,00,000). Thus, your working capital turnover ratio comes to be around 5 (approximately 5.143).
This means that for every ₹1 of your working capital, you made sales of nearly ₹5. In other words, every ₹1 that you invested into or allotted for your store’s operations made ₹5 of sales for you.
What does it tell you?
As mentioned above, the working capital turnover ratio denotes how efficiently a company is employing its working capital to carry on with its sales and growth. Moreover, to evaluate how effectively a company has been utilizing its working capital, analysts also compare its working capital ratio with those of other similar companies in the same industry. Then, they examine how the ratios have been fluctuating with time. Accordingly, they interpret the efficiency of the company.
Nonetheless, these comparisons are not quite useful if working capital becomes negative. When the working capital turns negative, the turnover ratio also turns negative. You can also refer to the formula to understand this.
A high (or positive) working capital turnover ratio suggests that the company is extremely effective in utilizing its short-term assets and liabilities to make sales. Put differently, it generates a higher rupee amount of sales for every one rupee of working capital it has used.
The example above represents a high working capital turnover ratio.
Therefore, a high working capital turnover ratio represents that a company is functioning smoothly and has no or limited requirements for additional funding. The cash inflow and outflow are regular, making the company flexible enough to spend its working capital for further expansion or inventory (production). Moreover, a company can also get a competitive advantage over other similar companies as it is an indicator of profitability.
However, an extremely high working capital turnover ratio can sometimes also reflect a lack of capital to continue with sales and growth. Gradually, such a company can turn insolvent in the near future if it does not get additional funds.
Apart from this, the working capital turnover ratio can be deceiving if the accounts payable of a company are very high. This would suggest that the company is facing trouble paying its bills as they remain unpaid. Such a company can even stop its operations due to a lack of funds.
Contrarily, a low working capital turnover ratio indicates that a company has invested in a very high number of accounts receivable and inventory to continue with its sales. This can result in excessive bad debts or dead inventory in the near future.
This can be understood with another example.
Assume that your art supplies store made sales of ₹35,00,000. Moreover, you’ve acquired a new client, a prestigious art college. However, as your new client made several orders on credit, you accumulated a huge number of unpaid invoices. Therefore, your working capital came out to be ₹45,00,000.
In this scenario, you computed your store’s working capital turnover ratio to determine your efficiency to use your working capital.
To calculate it, you divided your net sales (₹35,00,000) by your average working capital (₹45,00,000). Thus, your working capital turnover ratio comes to be 0.78, which is less than 1.
This means that for every ₹1 of your working capital, you made sales of nearly ₹0.78. In other words, every ₹1 that you invested into or allotted for your store’s operations and expansion could only make ₹0.78 of sales for you. This interprets that you could not efficiently utilize your assets for your store’s profits and growth.
Bottom line
While working capital shows the difference between a company’s current assets and current liabilities, the working capital turnover ratio evaluates the efficiency of a company in making sales for every rupee of its working capital that is put to use. However, a higher working capital turnover ratio is good. It shows the company’s ability to generate a larger amount of sales.
An exceedingly high working capital turnover ratio implies that the company has additional capital requirements for its future growth. Likewise, a negative working capital turnover ratio shows its inefficiency in utilizing its working capital. In this way, the calculation of this ratio ensures liquidity, prevents operational interruptions, and enhances the company’s overall financial health and value.
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