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How To Calculate Working Capital Turnover Ratio
As a business owner who wants to achieve growth, you may need to familiarize yourself with essential financial formulas. There are several formulas that a company can apply to determine how successful it is in different aspects of the business. One of them is the working capital turnover ratio. This ratio shows how efficient a business is at generating revenue for every dollar of working capital put to use. In this article, we will explore what the working capital turnover ratio is, how to calculate the formula, how to use the results in your business, and a way to keep the ratio high to ensure overall financial health.
What is the Working Capital Turnover Ratio?
The Working Capital Turnover is a financial ratio that indicates how effective a company is at using its working capital. Also referred to as net sales to working capital, it displays the relationship between the funds used to finance the company’s operations and the revenues the company generates as a result. By dividing net annual sales by average working capital, we get the working capital turnover ratio that is expressed in integers or times rather than as a percentage or proportion.
For example, a working capital turnover ratio of 3.0 implies that the business generates thrice its sales per dollar of working capital employed. In other words, this formula gives a company an accurate idea of the money it has available to put towards operations after all obligations are met (debts, bills, etc.). The calculation is usually made on an annual basis, but a company may choose to calculate this formula using net sales and average working capital for a particular period.
Formula To Calculate Working Capital Turnover Ratio:
The formula for calculating the ratio for a year is:
Working Capital Turnover = Net Annual Sales/Average Working Capital (Current assets — Current liabilities)
Net annual sales are the sum of a company’s gross sales (total sales) minus its returns, allowances, and discounts over the course of a year.
Average working capital refers to average current assets minus average current liabilities. Basically, working capital is the money that a business can spend to make essential payments, and manage and improve its operations, after all, bills and debt installments are paid.
Current assets stand for all company-owned assets that can be converted to cash within one year. They include cash, cash equivalents, accounts receivable, stock inventory, marketable securities, prepaid liabilities, and other liquid assets.
Current liabilities are a company’s short-term financial obligations that are due within one year. They include accounts payable, short-term debt, dividends, and notes payable as well as income taxes owed.
Net sales: $120,000
Current assets: $70,000
Current liabilities: $30,000
Average working capital = $70,000—$30,000 = $40,000
Working capital turnover ratio = $120 000/$40,000 = 3.0
Say Company A has $120,000 in net sales over a year. It has current assets of $70,000 and current liabilities of $30,000. So the average working capital during that period is $40,000 ($70,000—$30,000). The working capital turnover ratio is thus $120,000/$40,000 = 3.0. This means that every dollar of working capital produces $3 in revenue.
What the Ratio Tells You
The working capital turnover ratio is used to determine the relationship between funds and sales of the company, giving the number of times the working capital is turned over in a year. The ratio shows how effective you are in the utilization of your available capital in order to help your business thrive.
The best way to use the working capital turnover ratio is to track how the ratio has been changing over time and to compare it to other companies in the same industry or industry averages. This comparison is especially effective when the benchmark companies have a similar capital structure. However, the ratio must be analyzed and interpreted mindfully. A company should understand the context and the reasons why the ratio got higher or lower than before.
High and low working capital turnover
A high ratio indicates higher operating efficiency — the more revenue generated per dollar of working capital deployed, the better. A higher turnover ratio implies the company’s working capital management is more productive, most businesses aim to increase the number of ‘turns’. A high number of turns suggests the management uses the company’s short-term assets and liabilities to support sales very effectively, the business is running smoothly, and there is limited need for additional funding. Cash flows in and out regularly, giving the business freedom to spend capital on expansion or inventory.
On the contrary, a low ratio indicates the company’s working capital spending and day-to-day management are inefficient and generate less sales growth. A business invests in too many accounts receivable and inventory assets to support its revenue, which could eventually lead to the accumulation of bad debts and obsolete inventory write-offs. If a company’s working capital turnover ratio is way behind its peers, it may imply the business needs further adjustment of operational practices, as its sales are inadequate compared to the amount of working capital used.
The high turnover ratio can be deceiving. Management only appears to be effective with the working capital turnover ratio rising too high. When, in fact, the company needs a considerable raise of additional capital to maintain its sales growth due to the lack of working capital. As market demand remains high, insufficient working capital leads to the depletion of money to fund its business and optimize for high sales. The business becomes insolvent, and the collapse of the company may be imminent since it indicates that management cannot pay bills as they come due for payment. After calculating the working capital turnover ratio and discovering that it is excessively high, the company needs to analyze the financial situation and make appropriate optimization to avoid bankruptcy.
Keep the ratio high
An overall higher working capital turnover ratio leads to a higher return on capital employed, which can boost a company’s overall value within its industry, make your business more attractive to investors, and increase your company’s chance of expanding. Being a Buy Now Pay Later B2B solution, Comfi helps businesses increase the turnover ratio by incorporating split payments as an upgraded checkout to pay in installments.
On the one hand, as a SaaS vendor, you can leverage Comfi to increase your working capital turnover ratio by driving more revenue. Comfi enables you to push more ARR over MRR by allowing your customers to go for annual while still paying monthly, whereas you get paid the whole amount upfront. This is especially appealing for most of the customers if you do have a significant discount rate for annual contracts.
On the other hand, as an end-customer, you could avail Comfi to raise the working capital turnover ratio by lowering your short-term liabilities. As it goes from the paragraph above, as a user of SaaS services you can purchase annual subscriptions through Comfi, while still paying monthly with zero interest, thereby decreasing your monthly payment (if your vendors offer discounts on annual). Incorporating Comfi helps you plan accounts payable better, secure the runway of your business, lower your liabilities, and increase the working capital turnover ratio.
The working capital turnover ratio is a fundamental metric in working capital management. It is widely used to determine a company’s financial performance and analyze its overall practices to maintain smooth business operations. The working capital turnover ratio is best used to compare it with peer companies to provide deeper insights into the efficiency in the utilization of the working capital. If the ratio is much higher or lower than the industry’s average ratio, the company should optimize its operations and utilize funds most efficiently.
Incorporating Comfi is a great solution for keeping the turnover ratio high by increasing your revenue and lowering your liabilities depending on the business model you have.
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