Working Capital Turnover Ratio

As an entrepreneur, it is required to be updated for the company’s working capital turnover ratio. If it is not analyzed properly on a regular basis, then that may cause disruptions in the cash flow for daily operations. By examining this financial measure, it gets easy to decrease the production blockage and keep the business in profitable motion.

What is working capital turnover ratio?

A working capital turnover ratio is a financial ratio that is used to know whether the company is utilizing its working capital for creating sales or not. It can be found by dividing the net sales with average working capital. Increased turnover suggests more effective use of working capital to boost sales.

Formula for Calculating working capital turnover ratio

The formula to find the working capital ratio is given below: –

Working Capital Turnover Ratio =Net Sales / Average Working Capital

• Net sales indicate the total sales after removing sales returns, discounts, and financial allowances.
• The average of current assets less current liabilities during a certain time period is known as average working capital.

Average Working Capital = Beginning Working Capital + Ending Working Capital / 2

• Beginning working capital is the amount of money a business has available to cover short-term expenses at the start of an accounting period. It’s calculated by subtracting current liabilities (what the business owes) from current assets (what the business owns) at the beginning of the period.
• Ending working capital is the sum of working capital in hand at the end of the accounting period. It is measured by deducting current liabilities from current assets at the closure of the period.

Illustration of working capital turnover ratio

Let’s take an example of XYZ Pvt. Ltd. for demonstrating working capital turnover ratio.

For a specific year, XYZ Pvt. Ltd. holds the following information:

– Net sales: Rs. 6,000,000

– Beginning working capital: Rs. 900,000

– Ending working capital: Rs. 700,000

The working capital turnover ratio may be computed as follows:

Step 1: Measuring the average working capital.

Average Working Capital = Beginning Working Capital + Ending Working Capital / 2

= 900,000 + 700,000 / 2

= 1,600,000 / 2

= Rs. 800,000

Step 2: Applying the working capital turnover ratio formula.

Working Capital Turnover Ratio =Net Sales / Average Working Capital

= 6,000,000 / 800,000

= 7.5

For that specific year, ABC Pvt. Ltd.’s working capital turnover ratio is 7.5. This indicates that for every Rs. 1 in average working capital used during the year, the firm makes Rs. 7.5 in sales.

Decoding working capital turnover ratio

 High working capital turnover ratio: A high working capital turnover ratio indicates that money is flowing into and out of your company smoothly and to your benefit. Even with a very high ratio, it may use aggressive working capital management, which might lead to supply chain issues or out-of-stock situations.

Low working capital turnover ratio: When the working capital ratio is low, it shows that the expenditure spent is very high on the inventory and accounts receivable for sales. It could result in bad debt and outdated stocks.

Examining the working capital turnover ratio with industry standards and trends gradually for the particular company delivers an enhanced clarity of its effectiveness. There is no fixed criterion for a “good” ratio, but progressing steadily or in a balanced ratio regarding industry norms is largely beneficial.

Can working capital turnover ratio be negative?

The working capital turnover ratio is used to evaluate the effectiveness of the company with respect to the utilization of its working capital for stimulating sales. Hypothetically, this ratio can be precisely negative, but it is a rare situation and not a regular one.

The following situations might result in a negative working capital turnover ratio:

Notable variations in sales:

In case the company is facing a sharp decrease in sales while handling mostly a constant or high level of working capital, then this results in the negative turnover ratio. This is the indicator about the capital that is not utilized properly for the boosting sales.

Inaccurate computations or data:

Mistakes while doing financial calculations can result in an irregular negative ratio, though these occurrences are typically fixable with the help of careful examination and adjustments of the data.

Particular dynamics of the industry:

The industries that are having inconsistent sales patterns or considerable seasonal swings sometimes go through negative ratios because of the discrepancy between sales and working capital.

Benefits of working capital turnover ratio

• It offers insights about the effectiveness of the company for utilizing the working capital for the expansion of sales, delivering an estimation of operational efficiency.
• Aids in benchmarking and spotting patterns in efficiency gains or losses by facilitating comparisons within the sector or across time.

• Assists in making decisions about working capital management, including inventory control and accounts payable and receivable management.
• Allows for a better understanding of the company’s financial health by providing a snapshot of the state of daily operations.

Working capital turnover ratio drawbacks

• It offers a limited perspective on efficiency and leaves out other facets of total profitability or financial health.
• Because various sectors have distinct business strategies and operational needs, it may not be accurate to compare turnover ratios across them.
• Merely depending on this ratio might result in inaccurate judgments as it ignores subtleties in the data.
• For some analysis, the precision of the ratio may be distorted and rendered less dependable by variations in sales or working capital components across particular time periods.

Questions to Understand your ability

Q1.) What does the Working Capital Turnover Ratio measure?

A) The total profit generated by a business

B) The effectiveness of utilizing working capital to generate sales

C) The company’s overall financial health

D) The level of current liabilities

Q2.) Which of the following is the correct formula for calculating the Working Capital Turnover Ratio?

A) Net Sales / Ending Working Capital

B) Average Working Capital / Net Sales

C) Net Sales / Average Working Capital

D) Total Assets / Net Sales

Q3.) What could result in a negative Working Capital Turnover Ratio?

A) Significant increase in sales

B) Sharp decrease in sales while maintaining a high level of working capital

C) Proper calculation of financial data

D) High net profit

Q4.) What does a high Working Capital Turnover Ratio indicate?

A) The company has high levels of debt

B) Cash is moving in and out of the business effectively

C) The company has large inventories

D) The company has poor financial health

Q5.) Which of the following is a potential drawback of using the Working Capital Turnover Ratio?

A) It ignores profitability and financial health

B) It always reflects accurate operational efficiency

C) It is the same across all industries

D) It includes all business strategy details

Conclusion

In conclusion, the working capital turnover ratio is a useful measure of how effectively a company uses its working capital to generate sales. A higher ratio indicates better utilization, while a lower ratio may suggest inefficiencies. However, it is important to consider industry norms, trends, and other financial factors, as this ratio alone may not provide a complete picture of a company’s financial health.