Working capital productivity

The working capital productivity measurement compares sales to working capital. The intent is to measure whether a business has invested in a sufficient amount of working capital to support its sales. From a financing perspective, management wants to maintain low working capital levels in order to keep from having to raise more cash to operate the business. This can be achieved by such techniques as issuing less credit to customers, implementing just-in-time systems to avoid investing in inventory, and lengthening payment terms to suppliers.

Conversely, if the ratio indicates that a business has a large amount of receivables and inventory, this means that the business is investing too much capital in return for the amount of sales that it is generating.

Ideally, there is a midway point in this ratio that represents a reasonable usage of working capital to support the needs of a business. It is possible to drive for an excessively low proportion of working capital to sales, which can result in inventory stockouts and annoyed customers.

To decide whether the working capital productivity ratio is reasonable, compare a company's results to those of competitors or benchmark businesses.

To derive working capital productivity, divide annual revenues by the total amount of working capital. The formula is:

Annual revenues ÷ Total working capital

For example, a lender is concerned that Hubble Corporation does not have sufficient financing to support its sales. The lender obtains Hubble's financial statements, which contain the following information:

Annual revenues $7,800,000
Cash $200,000
Accounts receivable $800,000
Inventory $2,000,000
Accounts payable $400,000

With this information, the lender derives the working capital productivity measurement as follows:

$7,800,000 Annual revenues ÷
($200,000 Cash + $800,000 Receivables + $2,000,000 Inventory - $400,000 Payables)

= 3:1 Working capital productivity

This ratio is lower than the industry average of 4:1, which indicates poor management of the company's receivables and inventory. The lender should investigate further to see if the receivable and inventory figures may contain large amounts of obsolete items.

When using this measurement, consider including annualized quarterly sales in order to gain a better short-term understanding of the relationship between working capital and sales. Also, the measurement can be misleading if calculated during a seasonal spike in sales, since the formula will match high sales with a depleted inventory level to produce an unusually high ratio.