Working Capital Turnover Ratio: Meaning, Example, Limitation, and How To Calculate It

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.

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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

Here’s a simple example to explain how the working capital turnover ratio is calculated:

Let’s say a company has the following figures for the year:

• Net Sales: Rs. 5,00,000
• Working Capital at the start of the year: Rs. 80,000
• Working Capital at the end of the year: Rs. 60,000

Step 1: Find the Average Working Capital
Average Working Capital = (80,000 + 60,000) / 2 = Rs. 70,000

Step 2: Apply the Working Capital Turnover Ratio formula
Working Capital Turnover Ratio = Net Sales / Average Working Capital
= 5,00,000 / 70,000 = 7.14

This means the company earns Rs. 7.14 in sales for every Rs. 1 of working capital used during the year.

Advantages of working capital turnover ratio

1. 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.
2. 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.
3. 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.
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4. 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.

Disadvantages of Working Capital Turnover Ratio

The working capital turnover ratio mainly focuses on a company’s financial figures. While these are important, other non-financial factors also affect a business’s overall performance. For example, unhappy staff or a weak economy can impact business health, but the ratio does not reflect these issues.

Also, if a business has very high unpaid bills (accounts payable), the ratio might give a false impression. It may seem the company is doing well, but in reality, it could be having trouble paying its dues on time. So, while useful, this ratio should not be the only factor considered when judging a business’s condition.

Limitations of working capital turnover ratio

1. 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.
2. Industry Differences: Comparing working capital turnover ratios across different industries can be misleading, as business models and operational needs vary significantly between sectors.
3. Data Precision: Relying exclusively on this ratio may overlook important details or nuances in the underlying data, which could lead to inaccurate conclusions.
4. 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.

How to improve working capital turnover

Companies can improve their working capital turnover ratio by focusing on four key areas:

1. Increase Sales:

Net sales play a major role in this ratio. To boost it, businesses can try to sell more products, raise prices, or do both. But before increasing prices, it’s important to check how it might affect customer demand. Promotions can also help grow sales, though they may come with added costs.

2. Manage Inventory Better:

Holding on to slow-moving stock can hurt sales and waste storage space. Businesses can offer discounts or promotions to clear unsold items. Another approach is to use a Just-in-Time (JIT) method—ordering only what’s needed based on customer demand, so less stock is kept in storage.

3. Improve Customer Payments (Receivables):

If customers take too long to pay, it can create cash flow problems. To avoid this, businesses can offer early payment discounts or reduce payment terms—for example, asking for payment in 15 days instead of 30 or 60 days.

4. Manage Supplier Payments (Payables):

If a business has to pay its suppliers too quickly, it can affect cash flow. Try to negotiate longer payment terms with vendors. This gives more time to manage cash and use it for other business needs, like growing sales or handling urgent expenses.

Special considerations in working capital turnover ratio

Working capital management and the working capital turnover ratio are closely connected and important for a company’s financial health.

• Working capital management means handling a business’s short-term assets (like cash, stock, and money owed by customers) and liabilities (like bills and short-term loans) to make sure the company runs smoothly. The goal is to have enough funds for day-to-day operations without locking money in things that don’t generate income.
• Working capital turnover ratio shows how well a company is using its working capital to generate sales. It measures how many times working capital is used to support the business’s revenue.

Here’s how they are linked:

1. Better management improves the ratio: If a company reduces extra stock or collects payments from customers faster, it uses its capital more wisely. This helps increase the turnover ratio, showing the business is generating more sales with less money tied up.
2. Supports better decisions: A falling turnover ratio could be a warning that the business isn’t using its working capital well. This helps the company make smarter changes to improve how it manages cash, stock, and payments.
3. Creates a feedback loop: The turnover ratio reflects how good the company’s current strategies are. Based on this, businesses can tweak their approach to make operations more efficient.

In short, managing working capital well usually leads to a better turnover ratio, which means more efficient use of money and stronger financial performance.

Can working capital turnover ratio be negative?

The working capital turnover ratio shows how well a company is using its working capital to make sales. While it's usually a positive number, in rare cases it can turn out to be negative—though this is not normal or ideal.

A negative working capital turnover ratio may happen in certain situations, such as:

• Drop in sales: If a company’s sales suddenly fall but its working capital stays the same or increases, the ratio might turn negative. This suggests that the company isn’t using its money efficiently to earn revenue.
• Wrong data or miscalculations: Sometimes, errors in financial records or mistakes in the formula can give a false result. This can be fixed by checking and correcting the figures properly.
• Industry patterns: In some sectors with seasonal business or irregular sales, the ratio might look negative during quiet months. This usually balances out over time.

In short, a negative ratio is uncommon and often points to poor financial use or temporary situations.

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.