What is ‘working capital turnover’
Working capital turnover is a ratio that measures how efficiently the company uses its working capital to maintain a given level of sales. Also referred to as net sales to working capital, it shows the relationship between funds used to Finance the company’s operations and revenues the company receives as a result.
Breaking down the ‘working capital turnover’
Ratio working capital turnover is calculated by dividing annual net sales by the average amount of working capital – current assets minus current liabilities — during the same 12-month period. For example, company a has $ 12 million of net sales for the last 12 months. The average working capital over this period amounted to $ 2 million. The calculation of the turnover rate of working capital is $12,000,000/2,000,000$ = 6.
High turnover ratio indicates that management is very efficient with the use of the company’s short-term assets and liabilities to support sales, i.e., it generates a large amount of dollars for every dollar used working capital. On the contrary, a low ratio can mean that the business is investing in too many accounts receivable and inventory to support sales, which can lead to excessive bad debts or obsolete inventory.
To assess how efficiently the company to use working capital, analysts compare the ratios of working capital of other companies in the same industry, and watch how the attitude changes over time. However, such comparisons are meaningless when working capital is negative, because then the turnover ratio working capital will be negative.
Working Capital Management
To control how efficiently they are using their working capital, companies use the inventory Management and control accounts receivable and accounts payable. Inventory turnover shows how many times the company was sold and replaced over the period and the coefficient of accounts receivable turnover shows how efficiently they loan and collect the loan debt.
The pros and cons of high working capital turnover
A high ratio of working capital turnover shows that the company is running smoothly and has limited need for additional financing. Money comes and sends on a regular basis, giving the business flexibility to spend capital for expansion or inventory. A high ratio may also give businesses a competitive advantage over similar companies.
However, extremely high ratio, usually more than 80% can mean that the business has insufficient capital to support sales growth. Thus, the company could become insolvent in the near future. This is an especially strong when accounts payable is also very high, indicating that the company is experiencing difficulties with the payment of account due.