A company’s working capital and cash flow can tell you a lot about a business. The working capital turnover ratio measures how efficient a company is using its working capital in relation to a given level of sales which tells a lot about a company’s financial situation at the end of the period. In other words, it’s a snapshot of how efficient a company is at generating net annual sales. This is also known as net sales to working capital.
Advantages of working capital turnover ratio
The most obvious advantage of the working capital turnover ratio is that it gives business owners a very clear snapshot of how the company is operating and how well your competitors are doing. Other companies’ turnover ratios offer a good benchmark to measure how well you are doing compared with other businesses in the same trade. All of this can give you a competitive edge in the market. It should indicate that money is flowing smoothly in and out of your business meaning that you will likely avoid any financial trouble and that you will have a sufficient amount of inventory to avoid any shortages in the near future.
Disadvantages of working capital turnover ratio
It is more of a disadvantage to have a low working capital turnover ratio than it is to have a high ratio. With a low ratio, you could possibly run out of money to operate your business and suffer a total collapse of your business. However, if the working capital turnover is too high, you may not have enough working capital and need additional capital to support growth in the future which may lead to a company becoming insolvent.
Importance of Working Capital Turnover Ratio Calculation
The working capital turnover ratio calculation gives you a snapshot of how efficient your company is operating based on its working capital and sales. Working capital consists of a company’s current assets and current total liabilities.
What is the Working Capital Turnover Ratio Formula?
To understand the formula, first you need to know what working capital entails. Working capital involves current assets and current liabilities which can be found on the balance sheet. Working capital is equal to current total assets minus current total liabilities. To calculate the working capital turnover ratio, divide net sales by working capital. The calculation is typically made on an annual basis and uses the average working capital during that time period.
Net Sales ÷ (Beginning working capital + Ending working capital)/2
Example of the Working Capital Turnover Ratio
A particular company or lets say company A has $100,000 of net sales during a 12-month basis and an average working capital of $25,000 during that period. The working capital turnover ratio would be calculated as follows:
$100,000 Net Sales ÷ $25,000 Average Amount of Working Capital = 4.0 Working Capital Turnover Ratio.
How Do You Interpret Working Capital Turnover Ratio?
The companies working capital turnover ratio will tell you if your working capital turnover ratio is low, high or too high. A lower working capital turnover ratio indicates that there are too many accounts receivable and inventory asset amounts to support a healthy amount of sales. This could lead to bad debts and inventory write-offs which may lead to financial trouble. A higher working capital turnover ratio indicates that a company is efficiently using its short-term assets and liabilities to generate gross sales. A working capital turnover ratio that is too high could mean that the business does not have enough capital for future sales growth. This is an indication that the accounts payable is creeping upwards and that the company’s ability to pay its bills may be at risk.
What Is A Good Working Capital Turnover Ratio?
A high working capital turnover ratio reveals that the business is being very efficient with the firm’s short-term assets and short-term liabilities when factored in with sales revenue. A high turnover ratio indicates your company is running smoothly and that additional funding or resources are not necessarily needed.
What Does Working Capital Ratio Tell You?
Working capital ratio tells you how efficiently your business is being run. How well are you managing and controlling your short-term assets and short-term liabilities in comparison to sales.
What Does A Low Working Capital Turnover Ratio Indicate?
A low working capital turnover ratio indicates that the company needs to keep an eye on the accounts receivable and inventory. Somewhere along the line, the company has collected too many accounts receivable and invested in too much inventory to balance out their sales. As a result, this could lead to an excessive amount of bad debts and outdated or obsolete inventory. Eventually, the inventory assets become a loss that have to be written off. Negative working capital means that the current liabilities exceed the current assets and immediate action for additional funds is needed.