Working Capital Turnover Ratio
What is Working Capital Turnover Ratio and how is it calculated?
The Working Capital Turnover Ratio refers to the ratio of the Net sales and the average Working Capital of the company. It is a measurement of the efficiency with which the Working Capital is being used to generate the revenue of a business.
Since this is a ratio, it is communicated in numerical terms, and there is no unit of measurement. This can help to judge the amount of revenue that is generated for every INR 1 (or any other currency) that is spent in the Working Capital.
Example: Suppose that the Working Capital Turnover Ratio is equal to ‘4’ for a company. This would mean that INR 1 employed in the Working Capital, will generate a revenue of INR 4 for the firm.
Working Capital
The Working Capital of a business refers to the financial resources that are tied up in the Current Assets and the Current Liabilities. These short-term financial resources are needed to smoothly perform the daily operations in a company.
Depending on the method of calculation, there are two ways to define the Working Capital: Gross method and Net method.
Gross method
The Gross Working Capital refers to the sum of all the Current Assets of the firm. In this method of calculation, the Current Liabilities of the company are not considered. The idea behind this concept is that the management is more worried about the available investments, rather than the sources of the funds (liabilities).
Net method
The Net Working Capital refers to the difference between the Current Assets and the Current Liabilities of the firm. This is believed to give an actual measurement of the liquidity of a firm, because the surplus of the Assets over the Liabilities can be used as a buffer for covering any short-term obligations.
This method of measurement can be summarized by the below formula:
In order to calculate Working Capital Turnover Ratio, the Net Working Capital is used instead of the Gross Working Capital.
Working Capital Turnover Ratio formula
The Working Capital Turnover can be calculated for any particular time period. This means that if it has to be measured for a quarter, then the quarterly Sales and quarterly Working Capital data should be used. Similarly, if it has to be measured for a year, then the annual data can be used.
The Working Capital Turnover formula can be written as follows:
Sample calculation
Suppose that a company achieves sales of INR 100 crore (INR 100,00,00,000) in a Financial Year. Let us assume that the average Current Assets during the year were INR 85 crore, and the average Current Liabilities during the year were INR 45 crore.
So, the Net Working Capital of the company during the financial year will be: INR 85 crore – INR 45 crore = INR 40 crore. In this case, the Working Capital Turnover Ratio can be determined by the below formula:
\(WCT=\frac{100}{40} =2.5\)Ideal Working Capital Turnover Ratio
Theoretically, a higher value of this ratio would indicate a better efficiency in management of the Working Capital of a business. However, there is no fixed number or value that is ideal for a company to achieve. This is because the Working Capital requirements will depend on the nature of the market and the industry.
For example, the fund requirements of an Information Technology (IT) company will be very different from the fund requirements of a cement manufacturing company. Therefore, when the Working Capital Turnover Ratio interpretation is being done for a business, it is best to compare the values with the industry peers.
Alternately, the calculated values can also be compared with the historical values, to analyze the changes in operational efficiency.
Poor use of Working Capital
If the Sales to Working Capital ratio is less than 1 for a company, then it would mean that an increase/decrease in the Working Capital will generate a comparatively lower increase/decrease in the sales. For example, a ratio of 0.6 would mean that INR 1 of Working Capital is only generating INR 0.6 in sales/revenue. This can indicate a poor economic situation in the industry.
The Working Capital Turnover Ratio can also take a negative value, when the value of the Working Capital is negative. A negative number will obviously indicate financial stress, because the short-term liabilities are greater than the short-term assets. The ratio itself will lose significance when the Working Capital is negative for a firm.
Uses of Working Capital Turnover Ratio
As explained above, the Working Capital Turnover Ratio helps in an assessment of the efficient use of Working Capital. This can help in proper Working Capital Determination, and the management can plan to allocate sufficient funds towards the different components. It is very important to find the right balance between the short-term assets and liabilities of the firm.
If the Working Capital to Sales ratio of a company is worse than the ratio of its peers, then the company needs to enhance the operational practices. There are primarily two ways to improve the Working Capital Turnover Ratio of a business:
- Increase the sales, without a comparable increase in the Working Capital needs
- Efficient Working Capital Management to decrease the Working Capital requirements, for the same level of sales
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