Working Capital Turnover Ratio

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?

Working Capital Turnover Ratio = Revenue / Working Capital

Replacing working capital with current assets less current liabilities we get the following:

Working Capital Turnover Ratio = Revenue / (Current Assets – Current Liabilities)
  • 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

Income Statement for the year ended 31 December 2015
Revenue 44,000
Cost of goods sold 17,600
Gross profit 26,400
Operating expenses 13,500
Depreciation 6,500
Operating income 6,400
Finance costs 2,000
Income before tax 4,400
Income tax expense 900
Net income 3,500
Balance Sheet at 31 December 2015
Cash 500
Accounts receivable 12,500
Inventory 2,000
Current assets 15,000
Long term assets 39,000
Total assets 54,000
Accounts payable 9,000
Other liabilities 1,000
Current liabilities 10,000
Long-term debt 21,000
Total liabilities 31,000
Capital 6,000
Retained earnings 17,000
Total equity 23,000
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.
Working Capital Turnover Ratio November 6th, 2016Team

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