Working Capital Turnover
Businesses need to determine how well they are utilizing their working capital to improve sales and make profits. They can only measure the efficiency of their working capital using a working capital turnover ratio. And in this article, you are going to understand the basics of working capital, including working capital turnover meaning, how to calculate it, and an example of working capital turnover ratio.
So, first things first, what is working capital turnover?
What is Working Capital Turnover?
Before you understand what working capital turnover is, you need to know the definition of working capital. Working capital is the difference between the current assets in a company, including inventories, cash receivable, and cash, and current liabilities like accounts payable and debts. Working capital can either be positive or zero.
Positive Working Capital
Positive working capital means a company has more current assets than liabilities. With positive working capital, a company has enough funds that fully cover its short-term liabilities as they occur within a financial year. Such a company proves to have a strong financial muscle that enables its operations to run smoothly.
But hold on a little; too much working capital is not good either. Excess working capital arises from unused/unsold inventories or uncollected account receivables, which are not utilized effectively. The additional funds in inventories and accounts receivable are financed from long-term capital instead of short-term liabilities. Long-term capital should only be used to fund long-term investments for an optimum level of working capital. The optimal level ensures that a company strikes a balance between using the required funds and achieving investment effectiveness. Companies usually maintain working capital at 20-100 % of the total current liabilities to accomplish this balance.
Zero Working Capital
Zero working capital arises when a company has the exact number of current assets and current liabilities. This scenario is possible, especially if a company’s current liabilities fully fund the current assets. When a company has zero working capital, the overall investment effectiveness increases because the business doesn’t use long-term capital on short-term projects. Zero working capital has its limitations, too, as it carries significant risk on a company’s financial stability.
Now, back to the working capital turnover definition. Well, the working capital turnover ratio is a ratio used to measure a company’s efficiency in using its working capital to increase sales and the overall growth of the business. Working capital turnover is also known as the net sales to working capital. It entails comparing the revenues generated from the business and the funds financing the enterprise to make profits.
What Does Working Capital Turnover Tell You?
If your business is doing well, a high turnover ratio tells you that managing your company’s liabilities and short-term assets is very efficient in supporting sales. Simply put, a high turnover ratio shows that for the sum of the used working capital, it generated a higher dollar amount of sales. Meanwhile, a low turnover ratio indicates inefficiencies in running the business. A low turnover ratio may reveal that the company is investing heavily in many accounts receivable and inventories to boost its sales, sinking it into bad debts.
If you want to know how efficient a business is at utilizing its working capital, you need to compare it with the working capital ratios of the other companies. However, this comparison could prove futile if the working capital turns negative, influencing the turnover ratio to turn negative. Pay close attention to how the other companies’ ratios have changed over time.
Working Capital Turnover Calculation
To calculate the working capital turnover ratio, first determine a business’s working capital by subtracting current liabilities from current assets. Divide the net sales that the company made by the figure you obtained as working capital. Working capital turnover is calculated every year, and it uses the average working capital at the beginning and the end of a financial year. The calculation looks like this:
Can a Companies’ Working Capital Turnover Ratio be Negative?
Yes, a company’s working capital turnover ratio can be negative. A negative turnover ratio occurs when a company’s current liabilities are more than the current assets. When calculating working capital turnover, the working capital of a business is divided by the net sales. Net sales are not negative, so a negative working capital turns the turnover ratio negative. Negative working capital is closely associated with the current ratio, a value obtained by dividing a company’s current assets by its current liabilities.
When a current ratio is less than one, it implies that the current liabilities exceed the current assets, leading to a negative working capital turnover ratio. A temporarily negative working capital turnover ratio indicates a company may have experienced a significant cash outlay or large accounts receivable from vendors’ purchases of goods or services. However, an extended negative working capital turnover ratio could signify that a company is experiencing a crippling financial crisis. Such a company could be struggling to maintain standard operations and have to rely on stock issuances or borrowing to increase their working capital.
Working capital turnover ratio is affected by several different operational issues that influence changes in working capital. The ratio can detect warning signs of inefficiencies in a company’s operation through its working capital. For instance, a significant working capital amount could indicate that the business is withholding too many finances, limiting daily operations. In contrast, too little working capital could be a warning sign that a company is liberal with its funds, risking the finances allocated to running daily operations.
Working Capital Turnover Ratio Example
The following is a simple method that shows you how to calculate working capital turnover of a company:
Take an example of XYZ Limited, a manufacturing company that had net sales of $10 million over one year. The company had average working capital of $2 million during the same financial year. Use the following working capital turnover ratio formula to calculate the working capital turnover ratio:
Therefore, the working capital ratio for XYZ Limited is 5.0.
The working capital turnover ratio is an effective way that companies use to weigh the effectiveness of their working capital in improving sales and, ultimately, the company’s profits. The value is derived from dividing the net sales that the company made during a financial year and the average working capital of the same year.
A positive working capital turnover ratio signifies that a company has the considerable financial strength to run its operations. In contrast, a negative turnover ratio implies the company is undergoing serious financial challenges. Businesses need to strike a balance between the funds available in a business and their revenues for maximum investment effectiveness.