What is Working Capital Turnover?
How do you calculate capital turnover?
How does it work?
In this article, I will break down the notion of Working Capital Turnover so you know all there is to know about it!
Keep reading as I have gathered exactly the information that you need!
Let’s see what working capital turnover means and why it’s important!
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Let’s get started!
What Is Working Capital Turnover
Working capital turnover refers to a ratio providing insights as to the efficiency of a company’s use of its working capital to run the business and scale.
In principle, the working capital turnover (or net working capital turnover) measures how much money a company required to run the business compared to its ability to generate revenues from operations.
In other words, if a company is able to generate more revenues and profits from every dollar of money available in working capital means that the company is more efficient at using its working capital.
According to Investopedia, working capital turnover is defined as follows:
Working capital turnover is a ratio that measures how efficiently a company is using its working capital to support sales and growth.
As you can see from this definition, a company’s operating working capital turnover can be summed up as:
- A measure of efficiency
- Between a company’s working capital
- And how much revenue it generates
In essence, when a company has higher capital turnover ratios than compared to its peers and competitors, it is more efficient at generating sales for every dollar of working capital spent.
To understand working capital turnover, we must first understand the meaning of “working capital”.
Working capital is a company’s total assets less total liabilities.
When a business is able to generate sales, collect the funds, produce goods and services, generate new sales, and so on, it needs to have a good handle on its cash management, working capital, and cash conversion cycle.
Working capital allows a company to pay business operations, expenses, costs, bills, invoices, and support the company in generating revenues.
By keeping a sufficient amount of money in its working capital, a company is able to fund its business needs for a certain period of time without running the risk of having operational liquidity issues.
The better a company is able to produce, sell, invoice, and collect its invoices, the more efficient it can get in managing its cash flows and business cash needs.
Factors Affecting Working Capital
There are several factors that will have a direct impact on a company’s working capital:
- How much money a company has in its bank accounts
- How well it collects its account receivables
- How well it is able to sell goods kept in inventory
- The availability of lines of credit of other sources of funding
Money in the bank account will serve as an immediate source of funds to pay for any short-term financial obligations or business operational expenses.
If the company does not have the money sitting in the bank account, the next source of funding is from customers paying their invoices and how well a company is able to collect on outstanding accounts.
Then, a company can generate more working capital by selling goods and merchandise it has in its inventory to customers (leading to the company invoicing for the goods sold and then collecting).
Many companies also have a line of credit that they can use to manage ups and downs in their cash needs if they do not have enough cash in their bank accounts or money coming in from the collection from their account receivables.
Why Working Capital Turnover Is Important
Companies and business organizations want to use their capital as efficiently as possible to run their business.
In this process, a company will want to calculate its net working capital turnover to see how efficiently it is using its available capital to fund its business operations in relation to how much sales it is able to generate.
For this reason, a company will want to measure its working capital turnover to assess how well it is able to use its current assets and liabilities to support business sales and the growth of the business.
The higher the NWC ratio, the more a company is efficient in using its working capital to support sales.
On the other hand, when the capital turnover ratio formula provides a lower figure, it means that the company’s current assets are more tied up in accounts receivable or inventory which may not support sales as much.
Capital Turnover Formula
How to calculate capital turnover?
The working capital turnover equation is as follows:
WCT = NAS / AWC
- WCT = Working Capital Turnover
- NAS = Net Annual Sales
- AWC = Average Working Capital
The Net Annual Sales represents the company’s gross sales less any discounts or allowances.
The Average Working Capital is the company’s average current assets less its average current liabilities.
Another way of presenting the capital turnover formula is as follows:
WCT = NS / ](BWC + EWC) / 2]
- WCT = Working Capital Turnover
- NS = Net Sales
- BWC = Beginning Working Capital (for the period)
- EWC = Ending Working Capital (for the period)
This formula is used to calculate the WCT over a one-year period or a trailing 12-month period.
To see how a company is progressing in time, many organizations will measure use the capital turnover equation to measure their ratio and compare their current results to past ones.
Keeping track of how well a company is using its working capital to support sales can give a good indication of a company’s ability to effectively use its short-term assets to help grow the business.
You can find a capital turnover calculator online if you want to do a quick calculation and there is finance and accounting software that you can get to provide you further insights into your working capital management and utilization.
Working Capital Turnover Ratio
What does the capital turnover ratio provide as information?
The information provided by the working capital turnover ratio is important in the overall process of working capital management operations.
Having a good handle of your company’s cash flow is crucial to be able to manage the current business operations and execute intended business projects.
There are a few ratios that are crucial in providing a company with information about its financial positions and how working capital is impacted, namely:
- Working capital turnover
- Collection ratio or receivable turnover ratio
- Inventory turnover ratio
It’s important for a business to have sufficient funds in the short term to pay for its business and provide funding to all areas of the business driving sales and revenues.
In this context, companies are interested to know how quickly they can convert their current assets and liabilities into cash so they can internally continue funding the business.
To the extent a company is able to convert its accounts receivables, inventory, and short-term assets into cash in a timeframe allowing it to satisfy its financial obligations, then the company is in a good cash posture.
However, if a company is unable to convert its short-term assets into cash to replenish its working capital, then it may face cash shortages leading it to financial troubles.
Working Capital Turnover Example
Let’s look at an example of working capital turnover to better illustrate the concept.
Imagine that a company has:
- Net sales in the past 12 months: $10,000,000
- Working Capital at beginning of period: $6,000,000
- Working Capital at the end of the period: $2,000,000
In this case, the working capital turnover ratio will be $10,000,000 / [($6,000,000 – $2,000,000) / 2].
As a result, the working capital turnover ratio will be 5.
When the ratio is high, it indicates that the company is running smoothly and is able to fund its operations without additional sources of funding.
On the other hand, if the ratio is too high, it may suggest that the company will not have enough capital to support sales growth or the company may potentially become insolvent.
Capital Turnover Takeaways
So there you have it folks!
What is capital turnover?
How do you calculate working capital turnover?
What is a good working capital turnover ratio?
The working capital turnover refers to a company’s ability to convert its short term assets into cash to fund business operations.
The “working capital turnover ratio” is a measure of how efficiently a company is utilizing its working capital to support sales.
By definition, working capital is the company’s current assets less its current liabilities.
When a company has a high capital turnover ratio, it means that it is good at converting its short term assets and liabilities to support business operations leading to sales.
A low ratio can suggest that the company’s capital is getting stuck in inventory or account receivables and the company is not converting them to cash as quickly as they should.
Not managing inventory properly can lead to obsolete inventory assets.
Similarly, the lack of account receivable management can lead to bad debt and account write-offs.
In the end, working capital turnover and calculating the working capital turnover ratio is an important process of properly managing a company and ensuring that it can meet its business operational needs and handle its current liabilities.
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Working Capital Turnover Overview
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