A company’s performance can be gauged using several ways. Using a working capital turnover ratio is one of them. But what exactly is the working capital turnover ratio? Well, to understand it most simply, the working capital turnover ratio reflects a company’s efficiency in leveraging its working capital. It helps you tap into the sales and development of a company.
The working capital turnover ratio can also be used to understand the relationship between the finances used to run a company and the company’s generated revenue.
How to Calculate Your Working Capital Turnover Ratio?
The working capital turnover ratio can be calculated using a simple formula. Working capital turnover ratio = (Net Annual Sales ÷ Average Working Capital)
Here, the company’s net annual sales are the company’s total sales or revenue minus its discounts, allowances, and returns. The company’s average working capital is the difference between the company’s total assets minus total liabilities.
Let’s understand this with an example. Say a company made a net sales of ₹2,00,000 over the last year. The average working capital used over the same period was ₹20,000. Now, the working capital turnover ratio will be: ₹2,00,000 ÷ ₹20,000 = 10.0.
This means each rupee spent on working capital generates a revenue of ₹10.
Why Calculate Working Capital Turnover?
Calculating working capital turnover tells you a variety of things. First, it shows your effort in putting working capital into the company’s growth and development. The higher revenue you generate for each penny of working capital, the better your performance. This means the company is doing an efficient job of maintaining its gains and losses and improving sales.
Ultimately, a low working capital turnover shows you might be investing too much in inventory or receivable amount. This is a bad sign indicating your chances to struggle with debt and outdated inventory.
You can use your working capital turnover ratio the best way by making a smart comparison. Try analyzing the shift in your ratio over some time and compare the same with your competitor industries. This will help you understand your efficiency, identify your loopholes and work on them.
Working Capital Management & Financing
It is important for a company to efficiently manage their working capital. The same is important for a business’s day-to-day operations as well as long-term growth and development. This is why a lot of companies also rely on different sources of working capital financing to have easy access to working capital. This includes methods like revenue-based financing or working capital loans.
- Revenue-Based Source of Financing
This refers to a financing source that offers working capital to a company and promises to receive future revenue in return. It is suggested to use a working capital turnover ratio to analyze if you are making the most out of your working capital.
- Working Capital Loans
Working capital loans are majorly applicable for small to medium-sized enterprises. These are offered to a company to meet and fulfil their short-term obligations and not for expansion of product line or more. The loan is provided with a tenure and interest rate. The charges vary based on the discretion of the lending financial authority.
Wrapping Up
Working capital is nothing but a company’s total assets minus its liabilities. It is one of the tools to analyze the financial health of an enterprise. When you calculate the working capital turnover ratio, you can see how good a company is or isn’t in managing its working capital. You can use a simple formula of dividing annual sales by working capital. A high ratio signals good performance, while a low ratio is an alarming sign of excessive spending.
Use this educational tool to gauge your and your competitor’s performance, make comparisons, and improve accordingly.
References
https://www.investopedia.com/terms/w/workingcapitalturnover.asp
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