This month, in the last of our series on turnover ratios, we examine the working capital turnover ratio. The working capital turnover ratio is an activity ratio that measures how many times working capital is used to generate sales, ie revenue, during a specific time period. As such, the ratio is a good indicator of company growth and liquidity and is calculated as follows:

\(\mathrm{Working\: capital\: turnover} = \frac{net\: sales}{working\: capital}\)
The ratio is sometimes known as the capital turnover ratio, as net sales to working capital, or by the acronym WCTO.

Working capital is generally calculated as the company’s current assets less its current liabilities. Current assets include inventory and accounts receivable together with all other assets that will be held for less than 12 months. Current liabilities include accounts payable and payroll as well as any other liabilities, eg taxes, due in under a year.

Example

Company XYZ’s net sales year-to-date are €189,445, its current assets are €85,361, and its current liabilities are €43,262. Using the above equation, company XYZ’s working capital turnover is:

\(\frac{189,445}{85,361\: – \:43,262}={\mathrm{4.5}}\)
This means that during the period, the company has used (and of course replaced) its working capital 4.5 times to generate sales.

Interpretation of results

As with the majority of turnover ratios, the results should be interpreted on an industry sector basis to provide an accurate benchmark. However, in general, a high working capital turnover ratio usually indicates that the company is actively generating sales from its working capital, which is a positive indicator of future prospects. If the ratio increases significantly over the years however, or seems excessively high in relation to sector peers, this could indicate that the company is overtrading, ie taking on large orders that it does not have the resources to fulfil, and/or that a high proportion of the business’s assets are fixed assets (ie long-term assets such as buildings and machinery that are not easily converted into cash). Being top-heavy on fixed assets brings the available working capital down and means that the company lacks liquidity. This lack of liquidity could mean that the company would struggle to pay all of its debts.

Meanwhile, a low working capital turnover ratio could point to inefficiencies as the company is not generating a significant return on its assets, which can signal financial difficulty. Some companies, particularly those that are going through periods of rapid growth, do however run with negative working capital as they are able to generate cash extremely quickly. This is often the case in the food outlet or restaurant industry as customers pay for the goods up front. If the company’s working capital turnover is negative, this may be a sign of an efficient business strategy, particularly if inventory is tactically low, ie just sufficient to meet demand. A well-known organisation that has operated using this business model is McDonalds.

Many companies on the verge of bankruptcy also have negative working capital turnover though, so it is important to make sure that a company with negative working capital turnover has both low inventory and accounts receivable. If the company has high accounts receivable, this may indicate that it is not collecting its debts efficiently and that products have not been paid for up front. This, combined with a low inventory, would mean that the company is owed money and yet has no stock to sell to cover these debts.