We have many financial ratios to assess a company’s efficiency in managing assets, liabilities and revenues in order to make profit. Working capital turnover ratio is one of such financial ratios.
Working capital turnover ratio is calculated by using the following formula;
Working capital turnover ratio = Net Annual Turnover or sales / average working capital
Net annual turnover or sales is the sum of a company’s gross sales minus all allowances, and discounts over the course of the year.
Working capital of a company is calculated by taking out current liabilities from current assets. This means it’s defined as current assets minus current liabilities.
Average working capital = average current assets – average current liabilities
If a business has annual turnover of Rs 40,00,000 and average working capital of Rs 8,00,000, then the working capital turnover ratio is 5. i.e. Rs 40,00,000 / Rs 8,00,000.
What working capital turnover ratio tells you
Working capital turnover ratio indicates how effectively a company is managing its current assets and current liabilities for products of goods and services to generate revenue. In other words, the working capital turnover ratio indicates how efficiently the company generates revenue with its current assets and current liabilities.
Working capital turnover ratio of 5 indicates that the company generates 5 of revenue for every 1 of working capital.
If the working capital ratio is high, then it indicates greater efficiency as the company generates a high level of revenues relative to working capital. It means the management is very efficient in using the company’s short term assets and liabilities for supporting sales.
A positive working capital turnover ratio indicates that the company is using its current assets and current liabilities effectively.
In contrast, a low ratio signals that the company or business is investing too many in inventory and accounts receivable to support sales. Any kind of adversity, many lead to an excessive amount of bad debts or obsolete inventory.
In absence of adequate funds, many small and big businesses prefer to take working capital loans from banks and financial institutions to fund their short term capital requirement.
As an investor you need to look at the debt burden of the company on its balance sheet. If debt will have a long term impact on the company’s profitability, then many investors will avoid it.
The best way is to compare working capital turnover ratio with other companies in the same industry and look at how the ratio is changing over time.
When the company does not have enough funds to cover its short term obligations, financial insolvency can result and lead to legal trouble. To manage funds effectively companies use better inventory management, closely monitor accounts receivables and payables.
