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Working Capital Productivity
Description: The working capital productivity measure is similar to the sales to current assets ratio, in that both are used to see if there are sufficient assets available to support a given level of sales activity. The working capital productivity measure tends to be somewhat more accurate, since it subtracts current liabilities from current assets to arrive at a net current asset figure that may be considerably less than the total current assets figure used in the other measurement.
A company that can produce sales while maintaining a low proportion of working capital is extremely efficient at managing its resources, particularly in regard to collecting open accounts receivable quickly while keeping inventory levels low. Some enterprises achieve an impressive working capital productivity measure by imposing strict payment terms on their customers (such as payment in advance), while using drop shipping to avoid all inventory ownership.
Alternatively, an excessively low working capital productivity measurement reveals that a company is quite inefficient at producing sales, because it has too much invested in accounts receivable and/or inventory to produce a given level of sales. The measure can be compared to the results of competitors to see if the company is using its working capital in the most effective manner.
Formula: To calculate working capital productivity, diivide annual sales by total working capital. It may be useful to also calculate average working capital, in case the ending working capital for the reporting period is unusually high or low. The formula is as:
Annual Sales
Working Capital
Example: The Twosome Toboggan Company, makers of extra-large toboggans for wide loads, has reported a reasonable sales to current assets ratio of 4:1, which is comparable to the rest of the industry. However, one lender has heard rumors that the company is very slow in paying its bills, which indicates that its liquidity is not as good as indicated by the sales to current assets ratio. Accordingly, the lender obtains the company’s most recent balance sheet, which contains the following information:
| Annual sales | $6,500,000 |
| Cash | $150,000 |
| Accounts receivable | $400,000 |
| Inventory | $1,075,000 |
| Accounts payable | $695,000 |
With this information, the lender derives the working capital productivity measurement as follows:
Annual Sales
Working Capital
=
$6,500,000 Annual Sales
$150,000 Cash + $400,000 Receivables + $1,075,000 Inventory - $695,000 Payables
=
$6,500,000 Annual Sales
--------------------------------
$930,000 Working Capital
= 7:1 Working capital productivity
The presence of an inordinate amount of accounts payable greatly reduces the amount of working capital available to support sales, resulting in far fewer net assets than was initially indicated by the sales to current assets ratio. The lender should be extremely concerned about the ability of the company to continue as a going concern.
Cautions: Working capital productivity is generally a reliable measure. Its main failing is in the derivation of the annual sales figure in the numerator. If the sales figure used here departs considerably from the annualized amount of sales within the recent past, then it does not result in a good comparison of sales level to working capital requirements. This can also be a problem if the measurement is made at the end of a high seasonal sales peak, since annualized sales will appear to be quite high, while the inventory component associated with working capital will have been greatly reduced, resulting in a ratio that appears to be too high.
Similar Ratios
Sales to working capital ratio
Working capital ratio
Working capital turnover ratio