It usually takes a certain amount of invested cash to maintain sales. There must be an investment in accounts receivable and inventory, against which accounts payable are offset. Thus, there is typically a ratio of working capital to sales that remains relatively constant in a business, even as sales levels change.
This relationship can be measured with the sales to working capital ratio, which should be reported on a trend line to more easily spot spikes or dips. A spike in the ratio could be caused by a decision to grant more credit to customers in order to encourage more sales, while a dip could signal the reverse. A spike might also be triggered by a decision to keep more inventory on hand in order to more easily fulfill customer orders. Such a trend line is an excellent feedback mechanism for showing management the results of its decisions related to working capital.
The sales to working capital ratio is calculated by dividing annualized net sales by average working capital. The formula is:
Annualized net sales ÷ (Accounts receivable + Inventory - Accounts payable)
Management should be cognizant of the problems that can arise if it attempts to alter the outcome of this ratio. For example, tightening credit reduces sales, shrinking inventory may also reduce sales, and lengthening payment terms to suppliers can lead to strained relations with them.
Example of the Sales to Working Capital Ratio
A credit analyst is reviewing the sales to working capital ratio of Milford Sound, which has applied for credit. Milford has been adjusting its inventory levels over the past few quarters, with the intent of doubling inventory turnover from its current level. The result is shown in the following table:
|Quarter 1||Quarter 2||Quarter 3||Quarter 4|
|Total Working Capital||1,388,000||742,000||738,000||732,000|
|Sales to Working Capital Ratio||1.8:1||3.3:1||3.1:1||3.1:1|
The table includes a quarterly ratio calculation that is based on annualized sales. The table reveals that Milford achieved its goal of reducing inventory, but at the cost of a significant sales reduction, probably caused by customers turning to competitors who offered a larger selection of inventory.