How effectively does your company use its working capital? Are there inefficiencies in how you manage your current assets and liabilities?
If these are questions you’d like to answer, the working capital turnover ratio can provide the insights you’re looking for.
In this guide, we’ll take a look at the formula for working capital turnover, determine what it means for your business, and effective strategies to improve it.
What is working capital ratio?
The working capital turnover ratio demonstrates the relationship between a company’s net sales and its working capital. As such, it’s found by dividing net sales by the average working capital.
This ratio helps stakeholders — both internal and external — understand how well the company uses its working capital to generate sales and drive growth.
It helps provide insights into how effectively the company is managing key components of working capital, like its receivables, payables, and inventory, in relation to its sales performance.
Working capital ratio formula
How to calculate working capital turnover ratio
With the following formula, you will be able to calculate the working capital turnover ratio:
The net annual sales value can be easily found using the company’s income statement. It’s the difference between gross sales and any returns or discounts offered during the period.
The net sales value may already be reported on the profit and loss statement, with no additional calculations required.
It’s a bit more work to find the average working capital using the values reported on the balance sheet. Here are the necessary calculations:
Here, working capital is equal to the short-term assets minus the short-term liabilities.
Example of working capital turnover
Let’s say there’s a business, 123 Enterprises, whose balance sheet and income statement from the previous few years show the following values:
Using the formula from above, we first need to find the average by calculating the working capital:
Average working capital = (($450,000 - $185,000) + ($525,000 - $205,000)) / 2
= ($265,000 + $320,000) / 2
= ($585,000) / 2
= $292,500
We can then plug this value into the working capital turnover formula:
Working capital turnover ratio = $1,230,000 / $292,500
= 4.21
In other words, for every dollar of working capital 123 Enterprises has, it generates $4.21 in sales. A higher value would mean it’s able to use its working capital more efficiently to generate sales, while a lower value might indicate less efficient operations.
What does working capital turnover tell you?
The working capital turnover helps a company determine its operational efficiency and provides a gauge of its overall financial health.
A turnover that’s high is an indicator that the company is in good financial positioning and manages its working capital well to produce sales.
On the other hand, a lower ratio might show that the company needs to optimize its working capital management, which we’ll cover in further detail below.
In general, the working capital turnover can be used alongside other metrics like the current ratio or inventory turnover to inform strategy and planning decisions.
What is a good working capital ratio?
In general, companies strive for a high working capital turnover ratio. This shows that the company is efficiently using its working capital to support sales growth.
However, there can be such a thing as too high of a turnover. An elevated working capital turnover ratio might indicate that the company is not investing enough capital into its growth.
Of course, having too high of a turnover ratio is typically a better problem to have than one that’s too low. This may suggest that the company is mismanaging its working capital, like having a surplus of unsold inventory or slow collections of customer payments.
Because each industry has its own capital requirements and nuances, it’s best to compare a company’s working capital turnover to competitors and industry benchmarks to determine what’s a “good” value.
How to improve working capital turnover
Using the main components of the working capital turnover formula, there are a few ways for companies to improve this metric:
Grow sales
An important piece of the working capital turnover puzzle is net sales. Thus, a company can optimize this metric by improving sales performance.
There are a few ways to go about this, either by selling the same quantity of goods at a higher price, more goods at the same price, or a blend of the two.
Any changes in pricing strategy should be done after thorough analysis. Keep in mind that a price increase may affect customer demand for the product and doesn’t always equate to an increase in net sales.
Plus, there is a cost to engaging in promotional activities to sell more goods, which is also an important factor to consider.
Improve inventory management
Another strategy is to focus on inventory management. Slow-moving units that continue to take up space on shelves can be costly for the business and weigh on sales performance.
Teams may want to adjust their inventory strategy to get units moving more quickly, like by engaging in promotions or discounts to sell off unsold items.
It may also be worth considering a just-in-time (JIT) inventory practice, meaning companies only make orders with suppliers when it aligns with expected demand rather than keeping excess stock on hand.
Enhance accounts receivable management
If the company is not collecting the payments that customers owe them promptly, it can compromise the working capital turnover ratio and ultimately lead to cash flow problems. In turn, it can limit the company’s ability to meet its obligations or invest in growth opportunities to support sales.
Luckily, there are plenty of ways to improve the turnover of accounts receivable. For instance, businesses may choose to incentivize quicker payments by offering discounts.
It can also benefit companies to be more selective about offering lengthy payment terms to customers, extending net 15 terms instead of net 30 or net 60.
Optimize accounts payable management
Conversely, if businesses don’t have favorable payment terms with their own suppliers, it can lead to similar issues.
In this case, teams may want to work with their vendors to renegotiate and see if they qualify for a longer payment term.
Optimizing AP management gives the business a bit more leeway when it comes to timing outgoing payments. They’d have more flexibility to meet more urgent obligations in the meantime and put their capital to work for generating sales.
A quick note on working capital management
The turnover metric we’ve covered in this guide provides insights into a company’s working capital management practices.
This refers to how the company manages its current assets and liabilities to ensure healthy cash flows that can support operations.
At the most basic level, proper working capital management allows a company to meet its short-term obligations. It provides companies with extra cushion, allowing them to navigate through downturns without defaulting on payments.
On a bigger scale, working capital management supports profitability and helps a company free up cash to pursue growth initiatives.
Optimize AR and AP management with BILL
Managing working capital effectively is critical for any business focused on long-term growth and success. As mentioned above, enhancing AR and AP management are two effective ways to improve working capital turnover.
With a tool like BILL, companies can streamline their AP and AR management processes with just one intuitive platform, leveraging automation to reduce the amount of time spent on manual tasks.
BILL simplifies how you send invoices, helping you get paid up to two times faster with the use of automated reminders and scheduled recurring invoices. On the flip side, BILL can also help with supplier payments, automating approval routing and syncing with your accounting software.
Sign up for BILL today for a more intelligent way to create and pay bills, send invoices, and more.
