Working Capital Turnover Ratio: Meaning, Formula, Significance and Examples

The higher the ratio, the more efficient your business is at meeting short-term debts. A high ratio helps your company’s operations run smoothly and limits the need to secure additional funding. Before we can understand the working capital turnover ratio, we must first understand what working capital is. Working capital refers to the money your business has available to spend on essential payments, operations, etc. after all bills and debt installments have been paid. Working capital turnover ratio is an important activity ratio in accounting theory and practice. Activity ratios can be described as those financial matrices which determine the efficiency of a firm in leveraging its assets to convert them into sales.

• In order to match the time period of the numerator with that of the denominator, using the average NWC balances between the beginning and ending periods is recommended.
• If you want to see how your business performs compared to others, it’s important to focus on businesses in your same industry.
• This puts them at risk of running out of money to fund their business even though the ratio suggests they are doing better than the competition.
• Therefore, the company might soon become insolvent if it doesn’t raise more money to finance that growth.
• However, unless the company’s NWC has changed drastically over time, the difference between using the average NWC value compared to the ending balance value is rarely significant.

It looks like Red Company’s money works harder than Bue Company’s money is. The working capital turnover ratio is also known as net sales to working capital. The net working capital version of the ratio gives us a good idea relative to the company’s free cash flow, as we use the net working capital to help measure the free cash flow. Such comparisons, however, are useless when working capital goes negative since, at that point, the working capital turnover ratio likewise goes downhill. Analysts can compare a company’s working capital ratio to other businesses in the same industry and consider how the ratio has changed over time to determine how effectively a company uses its working capital. Non-operating assets – remove any cash and cash equivalents from the current assets.

Working Capital Turnover Ratio Definition & Calculation

If your company has a low ratio, this could be a sign that you’re spending on too many accounts receivable and inventory to support your sales. As such, you could end up with too much bad debt, or a load of obsolete inventory. That said, if your working capital turnover ratio is too high, it may be misleading. At first glance, it looks as though you’re operating at very high efficiency. But, the truth may be that your working capital is dangerously low. If you’re working with very low working capital funds, you may run out of money to fund your business.

The formula measures how funds go into operations and generate profits for your organization. The goal of the working capital turnover formula is to track efficiency over time and identify the areas of improvement. Say that Red Company had a net sales of \$500,000 last year and working capital of \$50,000. That means the company spent \$50, times to generate its \$500,000 in sales.

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It is extremely useful for the management, as it helps them ascertain the firm’s ability to make use of its current resources in facilitating its turnover. A lower ratio implies that the sales generated are lower than they should be, considering the amount invested in the business by way of working capital. Hence, the management can take necessary steps in order to improve its sales and facilitate growth and development. Using the assumptions above, the net working capital (NWC) equals the difference between operating current assets minus operating current liabilities, which comes out to be \$95,000. Therefore, we get a negative working capital turnover ratio, which indicates that Target is not generating revenue from its working capital. The working capital turnover indicator may also be misleading when a firm’s accounts payable are very high, which could indicate that the company is having difficulty paying its bills as they come due.

• In order words, assets such as cash and liabilities such as debt are financial assets that are not necessarily tied to the core operations of a company.
• The working capital version gives us a good sense of how Microsoft allocates its capital to drive sales.
• Suppose a business had \$200,000 in gross sales in the past year, with \$10,000 in returns.
• As a company accumulates more cash on its balance sheet, it can distort the working capital of the company.

The net operating cycle (NOC), often called the cash conversion cycle (CCC), is the shortest time necessary to convert net current assets and liabilities into cash. Working capital management supports maintaining the NOC’s smooth operation. Financial insolvency can happen when a business doesn’t have enough working capital to pay its debts, which can result in legal issues, the liquidation of assets, and even bankruptcy.

What Does Working Capital Turnover Tell You?

Non-operating liabilities – remove any debt or interest-bearing securities from the current liabilities. It tells you whether or not your leadership is good at managing cash flow within the organization. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.

It also could show us their ability to fund future growth opportunities. Okay, let’s dive in and learn more about the working capital turnover ratio. Grant Gullekson is a CPA with over a decade of experience working with small owner/operated corporations, entrepreneurs, and tradespeople. He specializes in transitioning traditional bookkeeping into an efficient online platform that makes preparing financial statements and filing tax returns a breeze. In his freetime, you’ll find Grant hiking and sailing in beautiful British Columbia. First, you need to gather the appropriate data to use in your formula.

How to Calculate a Working Capital Turnover Ratio

Determine your net annual sales by adding up your returns, allowances, and discounts. It’s worth mentioning know that just because you have working capital at your disposal doesn’t guarantee that you’ll be using it effectively. Since we now have the two necessary inputs to calculate the turnover ratio, the remaining step is to divide net sales by NWC.

Granted, some of the cash on the balance sheet fills a need and can act as short-term liquidity, but much of it tends to sit in fixed investments such as bonds. As a company accumulates more cash on its balance sheet, it can distort the working capital of the company. The better a company uses its working capital, the higher the sales.

We can do this by doing ratio analyses on the main components of operational expenses, such as working capital turnover, collection ratio, and inventory turnover ratio. It is meant to indicate how capable a company is of meeting its current financial obligations and is a measure of a company’s basic financial solvency. 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.

This is an especially useful comparison when the benchmark companies have a similar capital structure. Companies employ inventory management to control how effectively they use their working capital and closely monitor their accounts receivable and payments. The answers will vary depending on the industry, but a general rule is you want a working capital turnover ratio between 1.2 and 2. First, sales equal the annual revenues a company generates easily.

Differences Between Net Operating Working Capital (NOWC) and Total Operating Capital (TOC)

Using the previous example, assume you have the same net sales but instead have ​\$50,000​ in average working capital. A high turnover ratio indicates that management is leveraging the short-term assets and liabilities of the company very well to support sales. In other words, it earns more revenue per dollar of working capital employed. Working capital turnover, also known as net sales to working capital, measures the connection between the company’s resources and sales growth.

For example, if Texas Instruments buys more inventory, that reduces cash because of the purchase. Second, working capital consists of the components a company uses to generate those sales. J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor.

This means that you can convert assets and liabilities into revenue (cash) quickly. A low ratio can indicate over investment in current assets that are not supported by current sales. This can result in inventory obsolescence or accounts receivable bad debt writeoffs. If you want to see how your business performs compared to others, it’s important to focus on businesses in your same industry. The average working capital turnover for another industry may be very different than in yours. Paying attention to cash flow, current assets, and current liabilities continue to play a part of working capital management.