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There are a number of different formulas a small business can use to measure its financial health and performance. One of these formulas is the working capital turnover ratio. This metric measures how efficiently a company is using its working capital to generate sales and growth.Understanding your company’s working capital turnover ratio can help you better manage your business’s assets and liabilities to grow profits. Knowing and carefully managing this ratio can help you stand out in your industry, and also make it easier to qualify for a small business loan. Read on to learn what a working capital turnover ratio is, how to calculate this formula, and exactly what it can tell you about your business.
What Is Working Capital?
Working capital is the difference between a company’s current assets — including cash and other assets that can be converted into cash within a year — and its current liabilities, such as payroll, accounts payable, and accrued expenses. Essentially, this is the money that a business can spend to make essential payments and manage and improve its operations, after all bills have been paid.Positive working capital means the company can pay its bills and also invest to spur business growth. However, just having working capital at your disposal doesn’t mean you are making effective use of this money. The way to measure how wisely you are using your working capital is to calculate your company’s working capital turnover ratio.
What Is Working Capital Turnover?
Working capital turnover ratio is a formula that shows how well a company is utilizing its working capital to generate income. Also known as net sales to working capital, it’s calculated by dividing your net sales for the year by your working capital for that same year. The result shows the connection between money used to finance business operations and the revenues your business produces as a result.Generally, companies with higher working capital turnover ratios are more efficient in running operations and generating sales. Lower working capital turnover, on the other hand, can be an indicator that operations are not being run effectively.
Working Capital Turnover Formula
The working capital turnover formula is: Working capital turnover = net sales / average working capital Where:Net sales = sum of a company's gross sales minus its returns, allowances, and discounts for the yearAverage Working capital = Average current assets less average current liabilities
How Does Working Capital Turnover Work?
What qualifies as a good or bad working capital ratio number will depend on your industry. As a general rule, however, a company with a ratio around 1.2 to 1.8 is considered to be balanced. It’s likely that this company is healthy and able to pay its bills without trouble. If the ratio is less than one, however, it can indicate that a company cannot pay its liabilities. If the ratio stays low over the long term, it can lead to financial difficulties, even insolvency or bankruptcy.
Calculating Working Capital Turnover
Working capital turnover is one of the many important financial ratios that can help a small business owner better analyze and manage their company’s performance. To calculate this ratio, you need to first figure out your working capital. To do this, you take your current assets and subtract your total current liabilities. You can find both of these figures on your company's balance sheet.To get your average working capital, you can add your working capital at the beginning of the year to the working capital at the end of the year and divide by two. Once you know your average working capital number, you then divide your net sales for the year by your average working capital for that year. The result is your working capital turnover ratio, which tells you how many times per year you deploy that amount of working capital in order to generate that year’s sales figures.
How to Spot a Good Working Capital Turnover Ratio
Generally, a higher working capital ratio is better than a low one. That’s because the more revenue you can bring in for each dollar of working capital used, the better off your business is. A higher working capital turnover ratio indicates that money is flowing in and out of your company and helping it to make more money.However, the working capital turnover ratio shouldn’t be looked at in a vacuum. There isn’t one magic number. What’s considered a healthy ratio will vary from one industry to another, so it’s important to compare your ratio with that of other businesses in your industry.
Uses of Working Capital Turnover
The working capital turnover ratio is a useful metric for a small business owner to know. It’s simple to calculate, and can give you a very good idea of how hard you’re putting your available capital to work to help your business succeed. Knowing your working capital turnover ratio also allows you to compare your performance to that of your peers. If your ratio is coming up short, it can then motivate you to design ways to use your working capital more efficiently. Another good use for working capital turnover ratio is to compare your numbers from one fiscal period to another. This can help you see how well any changes you’ve put into effect are working.Working capital turnover ratio may also come into play if you’re applying for certain types of small business loans. In some cases, a lender will look at a business’s working capital turnover ratio, since it indicates whether they will be able to pay off debt in a set period and avoid running out of cash as a result of increased production requirements.
Pros and Cons of Using Working Capital Turnover
No financial metric is perfect. While the working capital turnover ratio offers many benefits, it also has some drawbacks. Here’s how they stack up.
Pros of Using Working Capital Turnover
Cons of Using Working Capital Turnover
Helps you better manage cash outflow and better assess cash inflow
Relies solely on monetary figures (and ignores other factors) to assess a company’s health
Allows you to compare your firm’s performance with that of your industry peers
Striving for a better turnover ratio can result in a ratio that is too high
Working Capital Turnover Calculation Example
Here’s an example of how to calculate working capital turnover ratio for a business and what it can tell you about that business. Let’s say XYZ company has $200,000 in annual sales and 100,000 in average in working capital. The working capital turnover ratio formula is: $200,000 net sales / $100,000 average working capital Working capital turnover ratio = 2A ratio of 2 is generally an indicator that the business is able to pay for its current liabilities while still maintaining its day-to-day operations, meaning that XYZ company is likely in good health. Keep in mind, however, that working capital turnover ratio should be compared with those of similar companies. If your business’s ratio is higher than your competitors', that’s usually a healthy sign. However, you don't want to have too high of a figure as that can hamper business growth.
Working Capital Management Tips
Working capital management is about monitoring and using your company’s current assets and liabilities to their most effective use. If your ratio is low, for example, it can indicate that your business is investing in too many accounts receivable and inventory to support its sales. This, in turn, could lead to an excessive amount of bad debts or obsolete inventory. A very high working capital turnover ratio, on the other hand, can indicate your small business does not have sufficient capital to support revenue growth. Over time, this could put your business at risk. It’s common for startups to seek lines of credit to ensure sales continue to grow while meeting financial obligations.
The Takeaway
Working capital turnover measures how efficiently a business is managing its working capital to generate revenue to grow the business. The ratio compares sales to current assets and current liabilities. A higher working capital turnover ratio is generally better, since it means more sales are generated per dollar of working capital. If it’s too high, however, then the business might need additional financing.
3 Small Business Loan Tips
Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.
Frequently Asked Questions
How is working capital turnover calculated?
What is usually considered a good working capital turnover ratio?
What is the working capital turnover ratio used to indicate?
Photo credit: iStock/Vanessa Nunes
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About the Author
Mike Zaccardi
Mike Zaccardi, CFA, CMT, is a finance expert and writer specializing in investments, markets, personal finance, and retirement planning. He enjoys putting a narrative to complex financial data and concepts; analyzing stock market sectors, ETFs, economic data, and broad market conditions; and producing snackable content for various audiences.
