What is the Working Capital Turnover Ratio?
The working capital turnover ratio shows the revenue generated by the working capital of your business. It is a measure of the efficiency with which the business uses its resources. It is calculated by dividing revenue by working capital. The ratio is sometimes referred to as the sales working capital ratio.
The term working capital refers to the net liquid assets of a business used in it’s normal day to day trading operations. In a simple business it would be calculated as inventory plus accounts receivables less accounts payable, representing the funding needed to buy inventory and provide credit to customers reduced by the amount of credit obtained from suppliers. In more general terms it can be defined as current assets less current liabilities.
What is the formula for the Working Capital Turnover Ratio?
Replacing working capital with current assets less current liabilities we get the following:
- Current assets are given in the balance sheet and includes cash, accounts receivable, and inventory.
- Current liabilities are also found in the balance sheet and includes accounts payable and short term (due in less than 1 year) debt. There is discussion as to whether overdrafts should be included in the current ratio calculation. Strictly speaking overdrafts are payable on demand and are therefore part of current liabilities. In practice under normal circumstances, a bank will view the business relationship as an ongoing one and overdrafts could be excluded. In the balance sheet format used below overdrafts have been left out of the calculation.
- Revenue is found in the income statement. It may be called sales or turnover.
The Working Capital Turnover Ratio Calculation in Practice
|Cost of goods sold||17,600|
|Income before tax||4,400|
|Income tax expense||900|
|Long term assets||39,000|
|Total liabilities and equity||54,000|
In example above revenue is 44,000 and the working capital is 5,000 calculated as follows:
Working capital = Current assets - Current liabilities Working capital = 15,000 - 10,000 = 5,000
The working capital turnover ratio is given by using the formula as follows:
Working capital turnover ratio = Revenue / Working capital Working capital turnover ratio = 44,000 / 5,000 Working capital turnover ratio = 8.80
For every 1 invested in working capital 8.80 is generated in revenue or revenue is growing 8.80 times faster than the working capital needed to generate them.
Now suppose for the same investment in working capital the business is able to increase the sales to 60,000, then the working capital turnover ratio will increase to 60,000 / 5,000 = 12.00. For every 1 invested in working capital 12.00 is generated in revenue.
What does the Working Capital Turnover Ratio Show?
The ratio shows how efficiently the resources of the business are being used to generate revenue.
A high upward trend in the working capital turnover ratio indicates that the business can generate more revenue without needing to increase working capital which in turn will reduce the amount of funding needed.
A downward trend in the working capital turnover ratio can indicate for example that accounts receivable (current assets) are increasing as sales increase. Eventually this will result in the business being unable to fund its working capital requirement and a cash flow shortage.
All assets of the business should yield their maximum return for the owners, so it is important to monitor any changes in the working capital turnover ratio.
Useful tips for using the Working Capital Turnover Ratio
- The ratio will vary from industry to industry, so it is important to make comparisons to similar businesses in your sector.
- There is no correct value for the ratio, the important thing is to ensure that the trend is upwards to show improving efficiency.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.