- What is Working Capital?
- Working Capital Turnover Ratio Formula
- How to Calculate Working Capital Turnover Ratio?
- Interpretation of Working Capital Turnover Ratio
- Advantages of Using a Working Capital Turnover Ratio
- Disadvantages of Using a Working Capital Turnover Ratio
- What is Working Capital Management?
The working capital turnover ratio is an accounting ratio that determines how effectively a business utilises its working capital to generate revenue. It is also an activity ratio. Working capital is the operating capital that a company utilizes in its day-to-day activities. This ratio is also known as the net sales to working capital formula. Working capital turnover is critical for any company. After all obligations have been met, this method gives a company an accurate estimate of how much money it has available to allocate toward operations (debts, bills, etc.). Companies that have a greater working capital turnover ratio are more efficient in their operations and revenue generation.
A high turnover ratio suggests that management is maximising the use of a company’s short-term assets and liabilities to boost sales. A low ratio, on the other hand, shows that a company is investing too much in accounts receivable and inventory assets to sustain its sales. This would in turn potentially lead to a large number of bad debts and obsolete inventory write-offs.
What is Working Capital?
The difference between a company’s current assets and current liabilities is known as working capital. It is calculated using the assets and liabilities listed on a company’s balance sheet. Assets such as cash-in-hand, bank balance, accounts receivable, inventory, advance paid are expected to be liquidated or converted into cash in less than a year. Hence, these assets are described as current assets. Similarly, liabilities such as accounts payable, wages, taxes payable, advance received, interest payable, monthly loan installments are due within one year. Such assets are known as current liabilities.
Working Capital Turnover Ratio Formula
The Formula for the Working Capital Turnover Ratio is:
Working Capital Turnover Ratio = Net Sales / Average Working Capital
Net Sales = Total Sales – Returns – Discounts
Average Working Capital = (Working Capital on The Beginning of the Period + Working Capital on The End of the Period) / 2
Working Capital = Current Assets – Current Liabilities
How to Calculate Working Capital Turnover Ratio?
Illustration on Calculation of Fixed Assets Turnover Ratio is:
|Current Assets As On 1st April 2021||Rs 12,00,000|
|Current Liabilities As On 1st April 2021||Rs 6,00,000|
|Current Assets As On 31st March 2022||Rs 15,00,000|
|Current Liabilities As On 31st March2022||Rs 7,00,000|
|Gross Sales||Rs 10,00,000|
|Working Capital As On 1st April 2021Current Assets – Current Liabilities||Rs 6,00,000(Rs 12,00,000 – Rs 6,00,000)|
|Working Capital As On 31st March 2022Current Assets – Current Liabilities||Rs 8,00,000(Rs 15,00,000 – Rs 7,00,000)|
|Average Working Capital(Working Capital on The Beginning of the Period + Working Capital on The End of the Period) / 2||Rs 7,00,000(R 6,00,000 + Rs 8,00,000) / 2|
|Net SalesTotal Sales – Returns – Discounts||Rs 8,80,000(Rs 10,00,000 – Rs 50,000 – Rs 70,000)|
|Working Capital Turnover RatioNet Sales / Average Working Capital||1.26 Times(Rs 8,80,000 / Rs 7,00,000)|
Interpretation of Working Capital Turnover Ratio
To determine how efficient a company is at using its working capital the analysts must compare working capital ratios. This comparison must be with other companies in the same industry. If the working capital is negative then these comparisons are pointless. This is because the working capital turnover ratio will always be negative due to the negative working capital.
High Working Capital Turnover Ratio
A high turnover ratio indicates that a company’s short-term assets and liabilities are being used effectively to drive sales. In other words, for every rupee of working capital employed, it generates a higher rupee amount of sales. A high working capital turnover ratio indicates that a business is running smoothly and requires little further funding. Money is moving in and out on a regular basis, allowing the company to invest in expansion or inventories. As a metric of profitability, a high ratio may provide the company a competitive advantage over similar businesses.
An exceptionally high ratio may suggest that a company lacks the capital to support its sales growth. As a result, unless it raises additional funds to maintain that growth, the company may become bankrupt in the near future.
Low Working Capital Turnover Ratio
A low ratio could indicate that a company is investing too much on accounts receivable and inventory to support sales. This could result in a high number of bad debts or obsolete inventory.
Advantages of Using a Working Capital Turnover Ratio
- When a company’s working capital turnover ratio isn’t monitored closely, it may run out of money for day-to-day operations and short-term loans. Working capital management may help to remain on top of the company’s accounts payable, accounts receivable, debt, and stock management by incorporating it into the business plan. This ensures that the company utilizes its working capital for optimal efficiency and management.
- Maintaining awareness of the company’s working capital turnover ratio can help minimize any disruptions in day-to-day operations by providing management with information that allows them to use cash most efficiently. Working capital can be effectively used to maintain operations, reducing any production bottlenecks and keeping the company as profitable as viable.
Disadvantages of Using a Working Capital Turnover Ratio
- A working capital turnover ratio only considers a company’s financial characteristics. While financial variables are crucial, non-financial elements can also have an impact on a company’s financial health. The working capital turnover ratio calculation ignores disgruntled employees or economic downturns, both of which can have an impact on a company’s financial health.
- When a company’s accounts payable are extremely high, the working capital turnover indicator may be deceiving. This ratio would be indicating that the company is struggling to pay its invoices as they become due.
What is Working Capital Management?
Working capital management is monitoring the progress of a company’s assets and liabilities in order to ensure that it has enough cash flow to cover its short-term operating costs and debt commitments. Working capital management includes keeping track of a variety of ratios, such as the working capital ratio, collection ratio, and inventory ratio.
By effectively utilising a company’s resources, working capital management can improve cash flow management and earnings quality. The timing of accounts payable is also part of working capital management (i.e., paying suppliers). A company can save money by deferring payments to suppliers and taking advantage of available credit. Alternatively, it can spend money by purchasing with cash—both options have an impact on working capital management.