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Meaning of Working Capital Turnover
Working capital turnover measures the revenue generated from every investment made in the form of working capital. The working capital turnover ratio helps the company to acknowledge the relationship between the working capital invested in the company to fund the routine operations and amount of sales generated through these operations.
Working Capital Turnover Ratio Formula
The formula for calculating the working capital turnover ratio is as follows:
Working Capital Turnover Ratio = Net Sales / Working Capital
In the above formula,
Working Capital = Current Assets – Current Liabilities
The efficiency of the management can be determined by knowing the working capital turnover ratio. If the ratio is higher, the management is very competent and efficient because they are able to utilize the short-term assets and liabilities of the company in a better way to support its sales. A higher ratio is a sign that all the operations of the business are running smoothly and there is no need for additional funds in the business.
On the other hand, if it is lower, it means that the company is having higher accounts receivables and inventory assets to support its sales. This is not a good sign, as it signifies that there is an excessive amount of out of date inventory and higher bad debts.
Let us understand the concept of working capital turnover ratio with the help of an example
Example of Working Capital Turnover
Calculate the working capital turnover ratio of Samsung Ltd. and LG Ltd. based on the following data. Compare and find which company has more favourable working capital turnover ratio?
|Net Sales (A)||172,215||63,982|
|Current Assets (B)||458,964||33,569|
|Current Liabilities (C)||242,439||27,149|
|Working capital (D) = [B − C]||216,525||6,420|
|Working capital turnover (A ÷ D)||0.79||9.96|
We know that Samsung and LG are competitors; the working capital turnover ratio helps in determining which company has better asset utilization. We have learned that higher working capital turnover ratio signifies higher efficiency of the management of the company. We can see in the above example that LG has a better working capital turnover ratio than Samsung. This means that LG has a competitive edge over Samsung.
Higher working capital is beneficial for the organization but sometimes there are some cons attached to it.
Advantages of Higher Working Capital Turnover Ratio
- It ensures smooth functioning of operations of the company.
- It eliminates the requirement of additional funds.
- It helps to ease business expansion.
- It gives a competitive edge over its peer.
Disadvantages of Higher Working Capital Turnover Ratio
- Extremely higher ratio sometimes reflects that the company does not have enough capital to support its sales growth.
- Higher working capital turnover often leads to the insolvency of the business.
The working capital turnover ratio is very significant for business organizations to compare its performance with the competitors. It gives a meaningful idea to the company in determining the efficiency in utilizing the working capital. However, the interpretation of higher capital turnover ratio should be done carefully. The picture is not always bright when the ratio is higher. Sometimes, a higher ratio is a sign of insufficient working capital in the business. Therefore, the analyst should use working capital turnover ratio formula after considering the various aspects of the business and the industry.