To continue to operate successfully, all businesses will need to be as efficient as possible. To monitor their efficiency, there are a number of different efficiency metrics that they can follow. One of the most common efficiency metrics that businesses use today to compare themselves to other businesses is working capital turnover.
This article will explain what working capital turnover is, how to calculate it, why it is good to have a high working capital turnover ratio, how to use it for comparison purposes, and what the drawbacks are.
What Is the Working Capital Turnover?
The working capital turnover measurement is a tool that companies use to determine how efficiently a business is using its working capital to fund operations and fuel business growth.
Analysts use it to determine how cash and other liquid assets impacts overall sales. In general, businesses that have a higher working capital turnover ratio or margin will be considered more efficient with their working capital.
How Do You Calculate the Working Capital Turnover?
Calculating working capital turnover is relatively simple. The calculation is net sales divided by working capital.
- Net sales are the gross revenue minus cost of goods sold, bad debt, and other relevant expenses. Net sales should be in calculation before backing administrative, overhead, and capital costs.
- Working capital is current assets minus current liabilities. Current assets include cash, accounts receivable, and inventory. Current liabilities include accounts payable, and short-term loans. However, they also include other debts that are due within a short period of time.
The net sales come from the income statement and working capital is a balance sheet item. Therefore, you will need to determine an average level of working capital for the time period that you test. For example, if you are testing working capital turnover for the 2017 fiscal year, you will need to calculate net sales for the year and determine what the average level of working capital was for the entire time period.
Benefits of Having a High Working Capital Turnover
Typically, having high working capital turnover is a positive.
- When a company has a high working capital turnover it shows that it is being very efficient in managing its short-term assets and liabilities. Also, the investments being made are doing a good job of translating to higher sales. This also normally means that the business has good cash flow.
- Also, it does not have the need for additional capital or raising a debt. This should allow a business owner to retain higher levels of control of their business and avoid taking out debt, which can come with higher interest and loan fee costs.
Businesses that do not have a high turnover ratio often have problems managing their cash flow. In many cases, having a lower turnover ratio will show that a business is investing too much in AR and inventory. This process at times could lead to a higher level of AR. Consequently, this could result in:
- Higher amounts of bad debt and collection cost;
- Inventory that could become stale.
There are clear benefits that come with having a high working capital turnover ratio. However, there are situations in which an extremely high ratio could be a bad thing. Businesses that have extremely high working capital turnover could have the ratio because they do not have the capital and debt necessary to grow. It could also be an indication that they are not utilizing leverage enough, which could also make it more challenging for a business to grow faster.
How Relevant Is the Turnover Ratio to Us?
All businesses should use working capital turnover and other efficiency metrics to compare their business’s financial position to prior periods. Ideally, working capital turnover should be calculated for each fiscal year and each fiscal quarter. A business should then be able to see how its efficiency is trending from one quarter to the next. This can provide a business with a clear indication as to whether it is getting more efficient or less efficient. If the level of efficiency appears to be declining, a business should determine why. Then, it needs to make changes to the business model to improve efficiency.
It is important to use the ratio to compare periods of time. Yet, a business also needs to be able to use it to calculate its ratio and compare it to other businesses in the industry. When you are able to compare the working capital turnover ratio to other businesses in your industry, you should be able to determine whether your business is more or less efficient. You may also be able to use the financial statements to look deeper into why your business is running better or worse than your competitive one.
Business practices from one industry to the next vary considerably. So, it is not necessarily relevant to compare the ratio with businesses that are in different industries.
The Main Drawback of Relying on the Ratio
Indeed, there are some great reasons to incorporate the ratio into your overall analysis for your business. However, there are some drawbacks as well. One of the main drawbacks is that it does not account for one-time events. This is even if they could impact your working capital position.
For example, if you take cash out of the business for either an owner distribution or to invest in capital, it will essentially reduce your working capital. When you go to calculate the ratio, the average working capital figure will then be lower as well. This will cause a higher efficiency ratio. This could make it appear that your business has gotten more efficient even though nothing has changed and it could make it harder to identify problems.
To the Sum
In conclusion, all businesses need to operate efficiently in order to be successful. To ensure that they are running efficiently, it is important to monitor it using a number of different metrics.
One metric that you can use to monitor business efficiency is the working capital turnover.
Images from pixabay.com.