The working capital turnover ratio indicates the rate of usage of the working capital net. This ratio reveals the number of times working capital is recirculated during a year. This measure is how efficiently a business uses working capital. A higher number shows efficient use of working capital, and a low ratio is a sign of inefficiency. A high working capital turnover ratio is not the best situation for any company, so caution should be exercised when looking at the ratio. The ratio is the best way to make a trend and comparative analysis for various firms within the same field and at different intervals.
Now, let’s check the interpretation of the working capital turnover ratio and intricacies.
Did You Know?
An organization’s working capital ratio measures its short-term financial health and efficiency. If the value is less than 1, this means the company has negative working capital (W/C). If the value is greater than 2, then the company is not investing the excess assets. A good value would be between 1.2 and 2.0.
Also Read: What is Net Working Capital: See Definition and Importance
What is a Working Capital?
Working capital is a must for every company, whether you’re a family-owned company, startup, or a well-established multinational corporation. The money is used to boost sales after debts and settle bills. Working capital comprises your assets in the present minus your current liabilities. In a brief overview, assets are the things your business owns, including cash and stocks. In contrast, liabilities relate to the amount your company owes to creditors, such as the accounts payable and salary.
Thus working capital is the spare cash left to be reinvested in the business to increase sales. It could be utilised to increase the effectiveness of internal operations and processes. Or, businesses may decide to provide working capital for new equipment or software. It is common for startups to require external financing to create enough working capital to support their sales growth. So, calculating the present and anticipated working capital ratios can be crucial in securing that financing.
Working capital is the capital needed by the company for the day-to-day operation of the business. Working capital is essential for any business to operate efficiently.
If there isn’t effective control of working capital, a business may run into a loss. Working capital is a short-term need for funds. The company should continuously check the status of its working capital and take compulsory corrective actions as quickly as possible. Positive working capital means that the company has enough short-term funds to cover short-term liabilities, which is beneficial for the business.
Working capital is the difference between current liabilities and assets. The working capital formula :
Working Capital = Current Assets – Current Liabilities
Working Capital Turnover
Working capital turnover of a business is the net sales of the business. Turnover is an important factor when calculating various ratios.
Net Sales or Turnover = Gross Sales – Discounts – Credit Note – Taxes
Once you understand what working capital and turnover mean, it will be easy for you to understand the purpose of the ideal working capital turnover ratio.
Working Capital Turnover Ratio
The objective is to attain an impressive proportion of the working capital turnover. A higher percentage indicates an excellent business’s financial future since the money spent will produce a high percentage of net sales.
However, some startups might have calculated their working capital turnover ratio at par. Although it’s not the best, there are plenty of options to improve this issue and eventually create an impressive turnover ratio.
A high working capital turnover is crucial to demonstrate that the company is effectively using its capital.
Working Capital Turnover Ratio Formula
The formula contains two elements, namely average working capital and net sales. Net sales equal the gross sale minus returns made by customers in the course of the period. Certain analysts prefer using the cost of selling goods (COGS) instead of net sales as the numerator of the formula. They believe that the selling cost is in greater direct correlation to the efficiency of how the business uses working capital.
Working Capital Turnover Ratio = Net Annual Sales / Working Capital.
Here, the working capital formula is:
Working Capital = Current Assets – Current Liabilities
The complete information needed to calculate the average working capital is available from the beginning/closing balance sheets.
How Can You Increase Your Working Capital Turnover Ratio?
It is beneficial to keep track of the ratio of working capital turnover over a short time because this allows management to determine improvement over time.
But, there are certain steps you could immediately start implementing to improve the working capital turnover of your business. Also, communication skills matter a lot here.
Offer Deferred Revenue Incentive
Do any of your clients pay you before availing of your service? The delayed payments can increase the amount of capital you have and provide your business with an up-front cash flow. However, deferred income will show as debt on your account statements. Also, it could be an effective method of creating credit.
To encourage customers to make an upfront payment, provide discounts or establish requirements in your client agreement. The management of this will lead to greater working capital.
Also Read: What is the meaning of Gross Working Capital?
Payable Days to Increase Days
Days payable outstanding is the number of days that a firm spends before settling its account. In the beginning, one with high days payable outstanding is advantageous because it indicates that you’re using the entire duration of your credit. This means you have more working capital to help fuel the growth of your business.
Every industry has its operating requirements when it comes down to the days payable outstanding. However, resolving accounts in time is crucial. So, make sure you optimise the terms of your account payables and settle on an agreement to gain access to working capital and establish a solid credit record.
Avoid Stockpiling
Keeping an inventory of your products is crucial for any product-selling company. However, it can be difficult to transfer the product if you’re overcommitting. Although it’s not a major problem over the long term, stockpiling could cause issues with cash flow in the short term.
Management of inventory can play a crucial aspect in maintaining more working capital. Businesses that can accurately determine when inventory is needed will have greater efficiency throughout operations. It will help maximise the remaining working capital after deducting assets from liabilities.
Important Points
- The working capital turnover ratio determines the amount of revenue earned by the company from the working capital funds available to it.
- It assists the business in comprehending the connection between working capital investments and the generation of revenue.
- The ratio is a performance measurement of how the company is managed and how the management handles the money.
- A higher percentage indicates that the company is well-managed and gives it a competitive advantage over its competitors.
- A proportion of 80% could be a sign that the company cannot raise enough money to sustain sales growth, further signalling the possibility of the company being insolvent soon due to the increased amount of account payables.
- A lower ratio may signify a company with higher accounts payables or inventories.
Conclusion
In general, a higher work-capital turnover rate is more beneficial, and a low ratio is a sign of inefficient use of working capital over time. The ratio must be compared with the recent years’ ratio, the ratio of competitors, or the industry’s average ratio to better understand the efficiency of the business in utilising their working capital. The working capital turnover ratio must be interpreted with care since a high ratio could also indicate a lack of working capital within the company. Most importantly, handling the calculations becomes very hard for businesses. In this case, platforms like Legaltree prove to be of great help.
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