The working capital turnover rate formula uses net sales as the numerator and working capital as the denominator. The common goal is to have a very high value which indicates leveraging net current assets in the sales process.
To prove its value and of course explain its flaws, this chapter will first explain the components of the formula.
Then, it will also explain the relationship of the two components and why this ratio has merit. Next this chapter will educate the reader about the existing flaws and its limited scope. Finally, this article will explain how it is best to apply the ratio to maximize its value in evaluating a small business.
Working Capital Turnover Formula
The formula’s two components are net sales and working capital. The following subsections explain these two values in more detail.
Many accountants fail to understand that there is a difference between revenue and sales. Revenue is all sources of income including sales (sales are a subset); interest on investments, penalties charged to customers and gains on the sale of fixed assets. Sales reflect the primary purpose (product or service provided) of the business. The formula is restricted to sales as the idea behind the formula is to relate sales to working capital.
Net sales refines sales further to the net final amount actually sold. Remember in many especially net sales is after returns and allowances)
Here is an example of the revenue section for identifying net sales.
Gross Sales $ZZZ,ZZZ
– Discounts (ZZ,ZZZ)
Adjusted Gross Sales ZZZ,ZZZ
. – Returns ($Z,ZZZ
. – Allowances (ZZ,ZZZ)
Subtotal Returns & Allowances (ZZ,ZZZ)
Net Sales ZZZ,ZZZ
Other Revenue ZZ,ZZZ
Total Revenue $ZZZ,ZZZ
The key is to use net sales. Both returns and allowances directly affect working capital. Returns increase the inventory balance and allowances decrease accounts receivable (traditional credits provided to long-term customers).
Net sales is a function of the income statement; whereas working capital is a function of the balance sheet. Working capital uses both current assets and current liabilities. Gross working capital (current assets) less current liabilities is net working capital.
For this formula to work, net working capital must be positive. Therefore all current assets have to exceed the value of current liabilities. This means the ratio must be greater than 1:1.
For the average entrepreneur, obtaining the two values is easy. First simply get net sales from a detailed income statement (profit and loss statement). Secondly, subtract current liabilities from current assets to obtain net working capital. Now both values are inserted into the formula to get the ratio.
The purpose of the formula is to evaluate the ability of a business to leverage its assets. In this case, the formula is not evaluating all assets just the ability to leverage net current assets (working capital). So for simplicity, assume net sales are $5 Million and net working capital is $200,000. The result is a ratio of 25:1.
If net sales increases to $5.5 Million then the rate increases to 27.5:1. This means the company is doing more volume of work,with the same level of net current assets. This is actually a positive sign. The principle is also true if net current assets decreases to $150,000. Look at this result:
Again, the formula is evaluating the ability to leverage assets. The higher the turnover rate, the better the leveraging of net current assets.
But now, let’s break this down further. Any entrepreneur or business owner would love to have more working capital. In reality, working capital is essential for long-term survival. Working capital exists for two reasons: 1) it increases solvency and 2) provides funds for business opportunities (purchasing fixed assets, utilizing early payment discounts, bulk purchases etc.). So the higher the working capital, the more secure the business operation. So assuming sales is again $5,000,000 and working capital increases to $300,000, the working capital turnover rate decreases to 16.667:1.
Think about this for a few moments, a higher working capital improves the current ratio; provides greater security; increases liquidity and is just downright good business sense. Yet an increase in net working capital decreases working capital turnover.
So which is better, a high working capital turnover or having more working capital?
There is another factor that affects this formula. It is the working capital cycle. This is the period of time it takes to completely cycle through the balance sheet the current assets. The cycle involves taking cash and buying raw materials (inventory) and adding labor to provide finished goods. Finished goods are then sold (sales) and customer receivables increase. Then in a reasonable period of time, the receivables become cash again completing the cycle. Each industry has different cycle times. Restaurants and service based operations have short cycle times of one week whereas a residential contractor will have cycle times exceeding six months.
Usually the longer the cycle the more likely the business uses long-term financing or equity to finance current assets. Therefore longer cycles tend towards greater net working capital to keep the operation functioning. Higher net working capital decreases working capital turnover rates.
So this means that each industry has its own reasonable working capital turnover rate. Oddly enough, there are no posted standards for the respective industries. However, the following table provides some guidance for some respective industries.
Industry Characteristics Reasonable Capital Turnover Rates
Food Service High volume, low sales prices, Reasonable working capital turnover ratios are
. very low net working capital between 4:1 and 15:1. Higher turnover rates
. balances, leveraged with indicate thin net working capital balances, too
. leases low and it is a sign of difficulty collecting.
amounts owed from customers (typically
. accounts receivable w/catering operations).
Transportation Steady sales and very high net Expect turnover rates of 10:1, higher ratios
. working capital balances for are a really positive sign of controlling assets.
. emergency purposes, a typical
. hauler will have net working
. capital > $100,000 for every
. $1,000,000 in sales.
Service Since this is a labor intensive Expect ratios greater than 35:1 and do
. business and high sales volume, not be surprised at 100:1 ratio.
. low net working capital balances
. create very high capital turnover rates.
Retail High sales volume, high net Ideal ratios of 15:1 or greater; this is one
. working capital balances; of the industries where is very desirable to
. have very high ratios.
Dealerships Very low net working capital Dealerships have very high sales volume
. balances as inventory is in dollars on very low unit transactions.
. customarily financed with High sales volume with low net working capital
. floor plans (lines of credit) balances create ratios of 100:1 or higher. It
. is not unreasonable to see ratios of 200:1.
Since the ratio is different for each industry, how exactly can an entrepreneur apply this ratio in evaluating a business?
Working Capital Turnover Rate Application
In the overall scheme of things, working capital turnover is an inferior business ratio. At the beginning of this chapter working capital turnover was introduced as a general activity ratio. Its inherent flaws include:
Broad Application – By comparing a sizable value of net sales against a netted amount from the balance sheet (current assets less current liabilities) the user is really evaluating the performance in an overall perspective. Net profit against assets is more prudent than this ratio. Simply put, the working capital ratio value isn’t very informative.
Volatile – The formula itself tends towards unstable outcomes. Anytime the ratio can fluctuate greatly because the denominator (working capital) changes slightly, the results are unreliable. For example, assume a radio station has net sales (from advertising) of $1.7 Million and its working capital increases from $93,000 to $111,600 (a 20% increase). Look at the change in working capital turnover:
. Before After
Net Sales $1,700,000 $1,700,000
Working Capital $93,000 $111,600
Ratio 18.3:1 15.2:1
A simple 20% increase in net working capital creates a negative 17% change in the turnover rate. Reasonable changes of 3 to 5% are acceptable, changes of 10% or more in one time period is volatile.
No Real Discernible Information – The final flaw is the actual outcome or derivative. As stated earlier, this formula is designed to identify the ability to leverage current assets. The higher the leverage the more likely management is efficient with net current assets. However, this efficiency is at the risk of solvency.
Thin working capital is very risky. To reduce risk, working capital must increase which decreases working capital turnover. In addition, this ratio isn’t even useful as a comparison tool over extended periods of time. This is due to the volatility of the working capital balance.
With these inherent flaws, how can this ratio be used to help an investor or management with small business models?
By their very nature, small businesses have thin or low working capital This is true for several reasons:
1) There is difficulty in obtaining unsecured long-term debt to increase working capital. Larger more stable operations have more access to long-term debt instruments to finance operations. Small businesses must rely on owners to infuse cash as needed.
2) In small business, any excess working capital is either used to purchase additional fixed assets or reward owners/investors with distributions/dividend This forces the business to carry thin net current assets.
3) Short-term borrowings especially via accounts payable are easy to acquire. In effect, gross working capital (current assets) is often financed with current liabilities.
With a small denominator in the formula the resulting ratio is almost certainly guaranteed to be high. So one useful attribute of a working capital turnover rate is a minimum threshold for the rate in small business. Here are the general guidelines and appropriate investigative steps:
. Rate Meaning and Investigation
. < 10:1 Could either be very low sales or a high net working capital balance. Look at the working capital value, if more than 50% of total equity then it is a sign of solid financial position. It is possible the business is posed for growth. If net working capital is high and less than 20% of equity, it is a sign of debt leverage so investigate the fixed assets to debt relationship. Low sales with negative profit is a serious problem.
. > 10:1<30:1 This is the normal range for small business. Use other ratios to evaluate the operation. This ratio is only stating that the business is operating its working capital appropriately. Use the quick and operating cash ratio to analyze the ability to pay current bills.
. > 30:1 This is an excellent sign if the company is generating operating cash flow. This means the company is spending working capital on more fixed assets, debt reduction or payment of dividends to owners. If operating cash flow is negative, a huge warning is appropriate. Cash to cover this loss must come from working capital which means potential solvency issues in the near future as net working capital is thin already driving the ratio higher.
. > 100:1 Sales are extreme therefore profit has to be high as a percentage of sales and operating cash flow has to be great for this level of sales to working capital. If profitability is slim and/or negative cash flow exists it means the product or service is woefully under priced. Although this ratio appears desirable, without the other positive attributes, financial performance can be catastrophic if management isn’t attentive to the signs.
Summary – Working Capital Turnover
The working capital turnover ratio is one of the activity ratios. It is generally a global business ratio with very little value. This is due to the more generic approach of the underlying formula. The formula is:
Since most small businesses have thin working capital balances, the denominator is small and the numerator is traditionally large. This creates very high ratios. In reality, small businesses should carry high working capital balances to provide long-term financial security. So lower working capital turnover rates are more appropriate for a small business which is counter-intuitive to business ratio application.
No matter what, never rely on this ratio to evaluate a business, especially small business. This ratio is not very informative and therefore more inappropriate when used with evaluating small business financial performance. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.