What is working capital turnover ratio?
Working capital turnover ratio is the ratio between the net revenue or turnover of a business and its working capital. For instance, if a business's annual turnover is Rs. 20 lakh and average working capital Rs. 4 lakh, the turnover ratio is 5, i.e. (20,00,000/ 4,00,000). The ratio indicates how effectively a company uses available funds for the streamlined production of goods or services.
A positive capital turnover ratio means that a business is using its working capital justifiably. On the other hand, a low capital turnover ratio means that the company is investing more in inventory. It may also mean that the organisation has too many outstanding liabilities with its suppliers, which increases the risk of bad debts.
The accumulation of such debts can hamper business operations considerably, but a Working Capital Loan from Bajaj Finserv can help. With this offering, you can get up to Rs. 80 lakh to maintain an optimal working capital turnover ratio and ensure healthy business operations. You can also opt for a Flexi loan, which is the perfect solution for dynamic capital needs.
The feature allows you to borrow as and when you need funds from an approved sanction and pay interest only on the amount withdrawn. You can also prepay as and when your business has excess cash, at no extra cost, and opt to pay interest-only EMIs at the start of the tenor to reduce the monthly outgo.
How to calculate the working capital turnover ratio
Calculating the Working Capital Turnover Ratio
The Working Capital Turnover Ratio is calculated by dividing a company's net sales during a given period by its working capital. The formula is expressed as:
Working Capital Turnover Ratio = Net Sales / Working Capital
Where:
- Net Sales = Total Sales – Sales Returns
- Working Capital = Current Assets – Current Liabilities
Alternatively, the ratio can also be calculated using the Cost of Goods Sold (COGS):
Working Capital Turnover Ratio = COGS / Working Capital
Where:
- COGS = Net Sales – Gross Profit
- COGS = Opening Stock + Purchases – Closing Stock
Example of working capital turnover ratio
Let's use the example of ABC Pvt. Ltd. to illustrate how to calculate the working capital turnover ratio.
Given details for ABC Pvt. Ltd. for the year:
Net Sales: Rs. 5,000,000
Beginning Working Capital: Rs. 800,000
Ending Working Capital: Rs. 600,000
Here’s how you calculate working capital turnover ratio:
Step 1: Calculate the average working capital.
Average Working Capital = Beginning Working Capital + Ending Working Capital / 2
= 800,000 + 600,000 / 2
= 1,400,000 / 2
= Rs. 700,000
Step 2: Use the working capital turnover ratio formula.
Working Capital Turnover Ratio =Net Sales / Average Working Capital
= 5,000,000 / 700,000
= 7.14
ABC Pvt. Ltd. has a working capital turnover ratio of 7.14 for the year. This means the company generates Rs. 7.14 in sales for every Rs. 1 of average working capital invested throughout the year.
Advantages of working capital turnover ratio
Efficiency Assessment: The working capital turnover ratio helps evaluate how effectively a company utilizes its working capital to generate sales. It serves as a key indicator of operational efficiency, highlighting how well the company is managing its short-term assets and liabilities.
Comparative Analysis: This ratio enables comparisons both within the industry and across time periods, allowing businesses to benchmark their performance. It also helps identify trends, such as improvements or declines in the efficiency of working capital utilization.
Informed Decision-Making: The ratio plays a crucial role in decision-making related to working capital management. It supports decisions on areas like inventory control, accounts receivable management, and accounts payable strategies, ensuring optimal use of working capital.
Insight into Operational Health: The working capital turnover ratio provides a snapshot of a company’s day-to-day operational health. It offers valuable insights into the overall financial well-being of the company by reflecting how well it is managing its short-term assets and liabilities to support sales.
Limitations of working capital turnover ratio
- Limited Scope: The working capital turnover ratio offers a narrow perspective on efficiency and does not account for other critical aspects of financial health or overall profitability.
- Industry Differences: Comparing working capital turnover ratios across different industries can be misleading, as business models and operational needs vary significantly between sectors.
- Data Precision: Relying exclusively on this ratio may overlook important details or nuances in the underlying data, which could lead to inaccurate conclusions.
- Temporal Fluctuations: Variations in sales or components of working capital during specific periods can affect the ratio's accuracy, making it less reliable for certain analyses or short-term evaluations.
Conclusion
The working capital turnover ratio measures how effectively a business utilizes its working capital to generate sales. A higher ratio indicates efficient use of funds, while a lower ratio may suggest excess investment in inventory or outstanding liabilities, potentially increasing the risk of bad debts. To maintain an optimal turnover ratio and ensure smooth operations, businesses can consider a business loan from Bajaj Finance. This loan allows you to cover working capital needs. The flexible repayment options, including interest-only EMIs and the ability to prepay without penalties, make it ideal for managing dynamic capital requirements.
Frequently Asked Questions
The working capital turnover ratio is a financial ratio that helps companies understand their efficiency in using their working capital to generate sales. It is calculated by dividing net sales by average working capital. Here is an example of this works:
A company that has net sales of Rs. 10,00,000 and an average working capital of Rs. 2,00,000 would have a working capital turnover ratio of 5 (10,00,000 divided by 2,00,000).
There is no such thing as a defined normal working capital ratio, as this number varies by industry. Generally, a higher working capital ratio is better for your company’s finances.
Yes, the working capital turnover ratio can be negative if a company has negative working capital, indicating more liabilities than current assets, which may signal financial distress.
No, the working capital turnover ratio is not a profitability ratio. It measures operational efficiency by assessing how well a business uses its working capital to generate sales, not profits.
