Understanding Working Capital Turnover

Understanding Working Capital Turnover

Let me explain the working capital turnover ratio to you directly: it reflects how well management uses a company’s short-term assets and liabilities to support sales.

You should know that working capital turnover measures the relationship between the funds financing a company's operations and the revenues it generates to keep going and make a profit. If you see a higher turnover ratio, it means the company is efficient with fluid and sufficient cash flow. We also call this net sales to working capital.

Key Takeaways

This ratio shows how effective a business is at generating sales for every dollar of working capital in use. A higher working capital turnover ratio is generally better because it means the company can produce more sales. But if it rises too high, it might suggest the company needs to raise additional capital for future growth. Keep in mind, the indicator can be misleading if a firm's accounts payable are very high.

What a High Turnover Ratio Means

When you look at a high turnover ratio, it indicates the company gets more dollars in sales than it spends on working capital. That's a sign of efficiency.

Working Capital Turnover Formula

Here's the formula you need: Working Capital Turnover = Net Annual Sales / Average Working Capital.

Net annual sales are the company's gross sales minus returns, allowances, and discounts over a year. Average working capital is average current assets minus average current liabilities.

What Working Capital Turnover Tells You

A high ratio tells you that management is efficient in using short-term assets and liabilities to support sales, generating more sales per dollar of working capital.

On the other hand, a low ratio might mean the business is over-investing in accounts receivable and inventory, which could lead to bad debts or obsolete inventory.

You should compare these ratios to other companies in the same industry to see true efficiency, and track changes over time. But if working capital turns negative, the ratio does too, making comparisons meaningless.

Working Capital Management

Managing working capital involves monitoring cash flow, current assets, and liabilities through ratios like working capital turnover, collection ratio, and inventory turnover.

This helps maintain the net operating cycle, or cash conversion cycle, which is the time to convert current assets and liabilities into cash. Without enough working capital, you risk insolvency, legal issues, asset liquidation, or bankruptcy.

Companies manage this by tracking inventory and accounts receivable and payable. Inventory turnover shows how often inventory is sold and replaced, while receivable turnover indicates credit and collection effectiveness.

Special Considerations

A high ratio means the company runs smoothly with limited need for extra funding; money flows in and out regularly, allowing flexibility for expansion or inventory. It can also provide a competitive edge in profitability.

But an extremely high ratio might show insufficient capital for sales growth, risking insolvency without more funds.

Importantly, high accounts payable can mislead the ratio, suggesting trouble paying bills on time.

Example of Working Capital Turnover

Take Company A with $12 million in net sales over 12 months and average working capital of $2 million. The ratio is $12,000,000 / $2,000,000 = 6.0, meaning every dollar of working capital produces $6 in revenue.

How the Cash Conversion Cycle Works

The cash conversion cycle adds days of outstanding inventory and sales, then subtracts days of payables outstanding. Days of outstanding inventory is the average time to sell inventory; days of outstanding sales is the time to collect receivables; days for payables is the time to pay owed amounts. This shows how long it takes to convert inventory to cash, useful for comparing similar industry companies.

What Is Working Capital?

Working capital is current assets minus current liabilities on the balance sheet, measuring short-term financial health. A positive number means the company can cover short-term liabilities in the next year.

What Is Obsolete Inventory?

Obsolete inventory is stock that can't be used anymore, often due to dropped demand. You have to write down or off its costs from the books.

The Bottom Line

The working capital turnover ratio measures how well a company uses working capital for growth and sales. The calculation is simple, and a high ratio shows efficiency, while a low one flags problems like excess inventory expenses. Use it to evaluate companies, but ensure they're in the same industry with similar inventory models.