One of the main responsibilities of those in the accounting profession is to tell the story of a business, but instead of using words, they use ratios and numbers to indicate how well a business is performing, explaining how profitable and efficient it is (or isn’t). There are many of these ratios in an accountants arsenal, but the one we are focusing on today is the working capital turnover. Though it sounds like a type of pastry, this ratio indicates how effectively a business uses its working capital.
Working Capital Turnover = Net Annual Sales / Working Capital
We’ll begin the explanation of this ratio with the sales part. The first part of the equation, net annual sales, is found on the company’s income statement, and may appear in one of two ways. It may first be listed as Net Sales, in which case you use that figure, as long as it’s for the entire year. If there’s no Net Sales account, you must use the Sales account. However, to get to net sales, you must take the sales amount, then deduct any returns, discounts, and allowances for damaged or missing goods, and your resultant number is net sales.
Working capital is used in the funding of operations, and to purchase inventory, which are then converted into sales revenue. This amount is found by subtracting current liabilities from current assets, which are found on the company’s balance sheet. If the working capital is being calculated on a trailing 12-month basis, which it usually is, the average working capital over the year may be used: (beginning working capital + ending working capital)/2. If you’d like to learn more about the balance sheet, this course on analyzing financial statements will simplify these potentially confusing accounting tools.
How it Works
The working capital turnover ratio, AKA net sales to working capital, is used to analyze the relationship between the money the company uses to fund operations and the sales that these operations generate. After calculating the working capital turnover, the accountant must then compare it to other companies in the same industry. Like all accounting ratios, there are no amounts that apply to everyone, and a high ratio may be successful to one industry, yet ruinous to another.
However, there are generalizations that can be made when discussing most accounting ratios. Generally, a high turnover ratio is a good indication that management is efficiently using the firm’s short-term assets and liabilities to support sales, and money is flowing in and out of the business smoothly, resulting in more flexibility. On the other hand, a turnover ratio on the lower side might mean that management is relying too much on accounts receivable and inventory assets to support its sales. This sort of situation could easily lead to an excessive amount of bad debts for the company, as well as obsolete inventory.
While a higher ratio is preferred, if a company’s working capital turnover ratio is excessively high, it may be an indication that their capital is insufficient to support their sales growth, and a collapse may be on the horizon.
The Working Capital Turnover Ratio in Action
Now that we’ve explained this ratio in words, we’ll briefly illustrate how it would be calculated in an example. Because we can’t fit in entire financial statements today, we will simply list the sample amounts, then show how to calculate the ratio using those numbers.
Jeremy’s Jams has sales of $147,000 for the year, with $6,000 in discounts and $8,500 in returns. Current Assets on the balance sheet were $33,000 and Current Liabilities were $15,000.
- First, you must find net sales. Since it’s not given, you must deduct any discounts and returns from sales: 147,000 – (6,000 + 8,500) = 132,500.
- Next, you must find working capital. Since we are given current assets and current liabilities to work with, we subtract liabilities from assets: 33,000 – 15,000 = 18,000
- Finally, plug these numbers into the formula: 132,500/18,000 = 7.36 – If you’d like to learn how to calculate this and other ratios using handy software, this course on QuickBooks Pro will make you the quickest accountant around.
Jeremy has a working capital turnover ratio of 7.36. He and his accountant will have to compare that to other businesses in his industry to find out if that’s any good or not. If not, they’ll have to figure out how to operate more efficiently. If you’d like to delve deeper into the finance world, this course on accounting and business will introduce you to some of the more important concepts.