Working capital turnover: understanding how it works

Introduction

To crush competitors, win clients, and secure a top market share in today’s highly challenging business environment can prove challenging. However, succeeding is every company’s goal, and the best way to measure this success is by counting your profits. This is where working capital turnover ratio is important.

So, how can you know if your business is making a healthy profit? By checking its working capital turnover, of course! 

Read more of this article to have a better understanding of how working capital turnover works.

What is working capital turnover?

Companies use the working capital turnover ratio to measure their success in terms of profits, sales, and overall growth. ‘Net sales to working capital’ is another name for the same concept. 

Working capital turnover unites two core business tools: a company’s working capital and profit turnover rate. You can use these two concepts to determine your firm’s working capital turnover ratio and understand the company’s sales performance. Moreover, calculating working capital turnover can help a company understand its sales efficiency and ability to sell a product or service.

Calculating an accurate working capital turnover ratio demands strict monitoring of all business operations. You must monitor how your company is generating sales and how much profit each sale provides while using the company's current assets.

What is working capital?

A company’s working capital is the net capital or financial liquidity maintained by a firm. It is a key indicator of the company’s financial well-being for the near future.

A firm can find its net working capital by measuring the monetary difference between its current short-term assets and current liabilities.

How do you calculate average working capital?

You can calculate the average working capital by measuring the difference between a company's average assets and average liabilities.

The average working capital helps provide key insight into your firm's average return on investment. However, the average working capital ratio may be unnaturally skewed if you include outlier values when calculating the average.

Hence, consider ignoring outlier asset and liability values when calculating the average working capital. This will yield a more realistic final average ratio.

How is working capital turnover different from working capital ratio?

The working capital ratio tells us about the company’s asset liquidity and its ability to pay for liabilities, including taxes. 

On the other hand, working capital turnover ratio talks about a company’s net sales per working capital unit or dollar. You can use it to understand how much money (profit) you’re gaining per dollar spent from your working capital. 

Hence, working capital turnover is a measure of efficiency, whereas the working capital ratio is a measure of asset management. 

Moreover, working capital turnover ratios indicate if your company needs additional capital investment and by how much it needs. 

An unreasonably high working capital ratio is a great way to understand how much additional capital to invest. 

How do you calculate working capital turnover?

working capital turnover ratio = Net sales / working capital 

To find the average working capital turnover ratio, use the average working capital value. Find this by combining the working capital from the beginning of the decided short-term period with the working capital from the period’s end, And then by dividing the sum of both by 2. 

Before calculating the net sales, it is important to determine the total revenue, cost of sales returns, allowances, and any discounts offered within the designated period. 

Then, apply this formula:

Net sales = Total revenue - (Sales returns + allowances + discount)

Why is working capital turnover calculated?

As a business owner or company manager, it’s your job to know what the firm’s financial future looks like. You can’t do this without understanding your business’ working capital turnover ratio. 

Working capital turnover ratios can tell you whether your business is:

1. Turning a high profit
2. Turning a low profit
3. Breaking even
4. Not generating a sustainable profit

Working capital management

First of all, you can calculate your sales growth and take the necessary steps to ensure sustainable business development and a smooth-flowing cash conversion cycle, or net operating cycle. 

Plus, these concepts are a crucial part of working capital management. Without knowing your working capital turnover ratio, you cannot manage funds effectively.

For example, suppose you find your company has a poor working capital turnover ratio. This suggests low financial profitability in the short run. So investing more capital into the existing business model may further reduce profitability in the long run.

Hence, you must either improve the business model or curb capital investment to avoid debt. 

What does a high working capital turnover ratio mean?

Every company’s primary goal is to generate a high working capital turnover ratio. A high working capital turnover ratio indicates healthy profit generation at a low investment capital or cost. Hence, it may have a competitive edge over other product or service providers. The result of a high ratio in working capital turnover is a high net annual sales receipt.

However, like all good things in this world, the working capital turnover ratio also has its limitations. So, if the working capital turnover ratio is too large, the company may have reached a saturation point. If it continues operations at its current level, it may remain stunted with little room for growth. 

To combat very high-efficiency ratios, any company with a high turnover ratio must input additional capital to nurture the corporation’s growth. 

How to maintain healthy cash flow cycles using working capital turnover ratio

We already know that a high working capital turnover ratio guarantees sufficient cash generation in the near future. Furthermore, you can use the turnover ratio to draft an estimate of how much profit to expect in the upcoming months.

Using a graphing software or drafting an excel sheet can help you keep track of the expected cash flow. Then, align your spending budget with your expected profits and accounts receivable to establish a healthy cash flow cycle for the upcoming quarter.

Final thoughts

To conclude, working capital turnover ratios help explain a company’s ability to generate profit by accounting for its operating expenses, net current assets or net working capital, and sales. 

It is a key indicator of rising sales and can be further analyzed to help avoid financial trouble and maintain cash flow. You can also use it to optimize your business to improve market share when competing against other companies in the same industry. 

Lastly, monitoring your business' working capital turnover ratio can help you understand when to alter company operations or finance additional funding to support sales and growth. For example, you can easily boost the profit generated per dollar of working capital by investing when your company has a high ratio of working capital turnover.

So, over time, you'll develop a progressively larger capital cushion with a large profit turnover. This will boost your company's overall financial health and improve the year's sales figures.

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