What Is Working Capital Turnover?

Last Updated December 18, 2024

As a business owner, it’s vital to understand the intricacies of your company’s finances, and it all starts with intelligent working capital management. One of the first steps to take when analyzing your financial outlook is learning about your working capital turnover.

Working capital turnover, sometimes referred to as “sales to working capital ratio,” is an important measurement of a company’s operational effectiveness, revealing how adeptly it utilizes its working capital at any given moment to fuel sales and foster expansion.

By having a greater understanding of your working capital turnover, you can make more informed decisions on where to invest and how to properly utilize resources. In this article, we’ll break down the details of the working capital turnover ratio, guiding you through its significance, calculation, and optimization strategies.

What Is Working Capital Turnover?

Working capital turnover is a financial ratio that gauges the efficiency of a company in using its working capital to support sales. Put simply, it reflects how well a company can generate revenue from its working capital. It’s a vital part of the business accounting process.

Working Capital Turnover Ratio Formula

The formula for working capital turnover is as follows:

Working Capital Turnover Ratio = Net Annual Sales ÷ Average Working Capital

A higher ratio indicates efficient use of working capital while a lower ratio may suggest inefficiencies or excessive capital tied up in assets.

The formula for working capital turnover is the same as sales to working capital ratio. To find your sales to working capital ratio, you will divide net annual sales by average working capital.

What Is the Significance of the Working Capital Turnover Ratio?

Calculating the working capital turnover ratio provides business owners a barometer for their company’s operational efficiency.

A higher ratio is indicative of a business’s ability to efficiently use its working capital to drive sales, denoting good financial health. On the other hand, a low ratio could imply that a company is not using its working capital effectively, possibly due to excess inventory or simply lack of sales, which could lead to cash flow issues.

Therefore, knowing your ratio is important because it signals necessary adjustments that need to be made to processes or products. For example, a low ratio might encourage a business owner to lessen costs for a certain product or service as a method to boost sales.

What’s more is that creditors and investors often scrutinize this ratio to assess a company’s viability and financial stability. A business demonstrating a consistent ability to turn its working capital into sales is generally deemed to be a safer investment.

How to Calculate Your Working Capital Turnover Ratio

In order to get an understanding of your business’s working capital turnover ratio, follow these steps:

1. Note Your Net Annual Sales
2. Calculate Working Capital at the Beginning of the Year
3. Calculate Working Capital at the End of the Year
4. Take the Average of These Two Figures to Find Your Average Working Capital
5. Divide Your Average Working Capital by Net Annual Sales

Working Capital Turnover Formula

In simple terms, here’s what the working capital turnover formula looks like:

Working Capital Turnover = Net Annual Sales ÷ Average Working Capital

As a refresher, you can find your average working capital by simply adding your working capital at the beginning of the period (year) with your working capital at the end of the period (year) and dividing that number by 2.

Working Capital Turnover Ratio Example

Let’s consider a hypothetical example to illustrate the calculation of the sales to working capital ratio.

Imagine a company with net annual sales of $500,000, current assets of $200,000, and current liabilities of $100,000 at the beginning of the year. By the end of the year, current assets have increased to $250,000, and current liabilities have increased to $150,000.

First, calculate the working capital at the beginning and end of the year. As a reminder, to calculate your working capital, you simply subtract your current liabilities from your current assets.

1. Net Annual Sales:

$500,000

2. Working Capital at the Beginning of Year:

$100,000

3. Working Capital at the End of Year:

$150,000

4. Find Average Working Capital:

($150,000 + $100,000) ÷ 2 = $125,000

5. Apply the Working Capital Formula

Net Annual Sales ÷ Average Working Capital

$500,000 ÷ $125,000 = 4

This indicates that for every dollar of working capital, the company generated $4 in sales, illustrating an extremely efficient use of working capital.

What Is a Good Working Capital Turnover Ratio?

A “good” ratio is contingent upon the industry and the nature of the business. Generally, a higher ratio is perceived positively, as it indicates more efficient use of (and a higher return on) working capital.

However, an excessively high ratio could also imply that a company is not investing enough in its future growth.

Working capital ratio benchmarks can vary quite a bit by industry. For example, according to this article on Medium.com, the retail industry has a benchmark of 5-10, while the construction industry has a benchmark of 2-4. Do research within your industry, especially your competitors, and compare your numbers against theirs. You’ll then be able to better gauge where your business lands on the spectrum.

How to Improve Your Working Capital Turnover Ratio

Improving your working capital is the most obvious tip to upping your ratio, as doing so is integral to enhancing your company’s financial health and operational efficiency. But let’s take a look at some more specific strategies that can help you improve your working capital turnover ratio.

1. Optimize Inventory Management

Effective inventory management is vital for any business that strives for optimal efficiency. This involves not only reducing excess stock to free up capital but also ensuring that inventory levels are aligned with current demand trends. Employing just-in-time (JIT) inventory practices, which is when businesses order goods from suppliers only when they are absolutely necessary, can reduce holding costs and prevent capital from being tied up unnecessarily.

2. Accelerate Accounts Receivable

Focus on streamlining the accounts receivable process. Faster collection of receivables improves cash flow, which in turn can be used to generate more sales. Consider offering discounts for early payments, employing stricter credit checks, and using invoice factoring to expedite cash inflow from sales.

3. Enhance Accounts Payable Practices

While managing receivables, it’s also vital to refine accounts payable strategies. Negotiating better terms with suppliers can extend the time your capital is working for you before it must be paid out. This doesn’t mean delaying payments to the detriment of supplier relationships, but rather, seeking mutual agreements that benefit both parties’ cash flow needs.

4. Reevaluate Your Pricing

There’s not a more obvious way to improve your sales to working capital ratio than by boosting sales. Don’t be passive if you’re not selling goods or services as you’d have hoped. Be proactive.

Look at how you’re pricing your goods or services and compare your pricing structure with industry norms and trends. The answer to your problem could be as simple as your product being too expensive. If that doesn’t work, revert back to your business budget, list of vendors, and sales ledger, and note where adjustments can be made to improve working capital.

Related: What Are My Working Capital Needs?

Working Capital Turnover Ratio FAQs

Here are common questions about working capital turnover and how you can improve it.

Is the working capital turnover ratio the same as the current ratio?

No, the working capital turnover ratio and the current ratio are distinct financial metrics. The current ratio focuses on a company’s ability to cover its short-term liabilities with its short-term assets, providing a snapshot of its liquidity. The working capital turnover ratio, however, measures how efficiently a business uses its working capital to generate sales.

Is the working capital turnover ratio the same as the cash turnover ratio?

The working capital turnover ratio and the cash turnover ratio serve different purposes. The cash turnover ratio measures how efficiently a company generates sales from its cash on-hand, whereas the working capital turnover ratio considers all current assets and liabilities.

What is the sales to working capital ratio?

The sales to working capital ratio is a liquidity measure that reflects how efficient a company is at generating sales revenue from its average working capital. To find your sales to working capital ratio, you can divide net annual sales by average working capital. Sales to working capital ratio and working capital turnover ratio can be used interchangeably.

How is the working capital turnover ratio expressed?

The working capital turnover ratio is expressed as a numerical value, and it can sometimes be converted to a percentage for easier comparison across different businesses or industries.

What is the average working capital turnover ratio?

The average working capital turnover ratio varies significantly across industries. For your business, compare your ratio to industry benchmarks and competitors to determine if your organization is performing at an optimal level.