Working capital turnover ratio definition
/What is the Working Capital Turnover Ratio?
The working capital turnover ratio measures how well a company is utilizing its working capital to support a given level of sales. A high turnover ratio indicates that management is being extremely efficient in using a firm's short-term assets and liabilities to support sales. A business that consistently operates with a high working capital turnover ratio needs a smaller ongoing cash investment than its competitors to produce the same level of sales that they are generating.
Conversely, a low ratio indicates that a business is investing in too many accounts receivable and inventory assets to support its sales, which could eventually lead to an excessive amount of bad debts and obsolete inventory write-offs.
Working Capital Turnover Formula
To calculate the ratio, divide net sales by working capital (which is current assets minus current liabilities). The calculation is usually made on an annual or trailing 12-month basis, and uses the average working capital during that period. The calculation is:
Net sales ÷ ((Beginning working capital + Ending working capital) / 2)
Example of the Working Capital Turnover Ratio
ABC Company has $12,000,000 of net sales over the past twelve months, and average working capital during that period of $2,000,000. The calculation of its working capital turnover ratio is:
$12,000,000 Net sales ÷ $2,000,000 Average working capital
= 6.0 Working capital turnover ratio
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Issues with the Working Capital Turnover Ratio
An extremely high working capital turnover ratio can indicate that a company does not have enough capital to support its sales growth; collapse of the company may be imminent. This is a particularly strong indicator when the accounts payable component of working capital is very high, since it indicates that management cannot pay its bills as they come due for payment.
An excessively high turnover ratio can be spotted by comparing the ratio for a particular business to those reported elsewhere in its industry, to see if the business is reporting outlier results. This is an especially useful comparison when the benchmark companies have a similar capital structure.
A concern with this ratio is that it reveals no useful information when a business reports negative working capital. In this situation, the ratio is also negative, so other analyses will need to be conducted to gain a better understanding of the liquidity of the business.
Terms Similar to Working Capital Turnover Ratio
The working capital turnover ratio is also known as net sales to working capital.