There are several accounting parameters, which are used to measure the efficiency of a company. Working capital turnover ratio is such a parameter. We will know more about working capital turnover ratio in this blog post.
What is Working Capital Turnover Ratio?
Before looking into the working capital ratio we first have to understand what is working capital?
Working capital is the difference between current assets and current liabilities of a company.
Working Capital= Current Assets-Current Liabilities
Working capital ratio is an accounting ratio which determines how efficiently a business is utilizing its working capital to generate a given level of sales. It is obtained by dividing the net annual sales by the working capital of the company.
ABC Pvt. Ltd. has $12.5 million of current assets and $3.25 million of current liabilities. Net annual sales of the company is $18.35 million. Now we will calculate the working capital turnover ratio, using the above data.
Working capital of the company = current Assets-current liabilities
= $9.25 million (12.5-3.25)
=1.459 (approx. 1.46)
Let us look into the data of a company, say, ABC Pvt. Ltd.
Calculation of the Working Capital
Beginning working capital = (current assets- current liabilities) of March 2020 = 225112-246762= -21650
Ending working capital = (current assets- current liabilities) of March 2021= 353810-224537= 129273
The working capital will be the average of beginning working capital and ending working capital= (129273-21650)/2= 53811.5
Working Capital Turnover Ratio= Revenue/Average Working Capital= 614350/53811.5= 11.41
Interpretation of Working Capital Turnover Ratio
The working capital turnover ratio should be seen with other ratios be compared with industry standards to determine the correct financial position of the company. If the working capital turnover ratio of a company is high, it means that the company generates more revenue than its working capital. When the current assets are more than the current liabilities, the working capital of the company is positive. In this case, the inventory level is lesser then the payables and hence the working capital is low. It results in high inventory capital turnover ratio.
Significance of Working Capital Turnover Ratio
Working capital turnover ratio is a crucial parameter which determines the status of the liquidity of a company.
|Value of Working Capital Turnover Ratio
|Working Capital Turnover Ratio<1
|Potential future liquidity problem
|Working Capital Turnover Ratio=1.5 to 2
|Working Capital Turnover Ratio< or = 0.5
|The business should evaluate its operations and introduce more cost effective solutions
Benefits of using Working Capital Ratio
There are several benefits of using the working capital ratio for the company. Some of the benefits of it are as follows:
Indicator of Liquidity
If the working capital ratio is low, it means the company is facing financial issues and the company is having insufficient funds for day to day operations. The company may even have short term debts. A high working capital turnover ratio indicates that the company is cash rich and is utilizing its working capital efficiently.
Increased overall financial health
A good working capital turnover ratio indicates that the company is at good financial standing and is having sufficient cash flow to support day to day operations of the company. This also indicates that the company does not depend on external funding and is on low debt. A high working capital turnover company can hence attract more investors.
Enhance value of the company
A good working capital turnover makes the company more profitable and hence the value of the company is enhanced as compared to its competitors. The investors also give more value to a company having high working capital turnover ratio.
Disadvantages of Working Capital Turnover Ratio
While there are many advantages of Working Capital Turnover Ratio, some of which are discussed above, there are some disadvantages of this method as well. Some of the disadvantages are discussed as below:
Only Considers Monitory Factors
The working capital turnover ratio only considers the monitory factors while some non-monitory factors may also impact the financial health of the company. For example, the working capital turnover ratio calculation ignores the unsatisfied employees or economic downturn, both of which may impact the financial health of the company adversely.
A High Working Capital Turnover Ratio Can Be Negative Also
While the high working capital turnover ratio indicates positive things about the company, it may sometimes be negative also. A high working capital turnover ratio may also indicate that the company needs more working cash flow to keep pace with the business development or the sales growth it is encountering. This is also a strong indicator that the accounts payable component of working capital is very high, since it indicates that management cannot pay its bills as they are due for the payment. If the company does not adjust its working capital to sales ratio, it may become insolvent in the future. If you find the working capital turnover ratio excessively high, you may need to analyze its financial situation and make appropriate adjustments to prevent collapse.
Working capital turnover ratio is an important financial ratio which is used by the analysts as well as the investors to find out how efficiently a company is utilizing its working capital. This ratio tells us about the liquidity status and eventually the financial health of the company. To access the overall financial standing of the company, it is important to look at the working capital ratio along with other accounting ratios and also with the working capital turnover ratio of the industry.