Notice: Function _load_textdomain_just_in_time was called incorrectly. Translation loading for the armember-membership domain was triggered too early. This is usually an indicator for some code in the plugin or theme running too early. Translations should be loaded at the init action or later. Please see Debugging in WordPress for more information. (This message was added in version 6.7.0.) in /home1/wanrru6iyyto/public_html/wp-includes/functions.php on line 6114

Notice: Function _load_textdomain_just_in_time was called incorrectly. Translation loading for the ARMember domain was triggered too early. This is usually an indicator for some code in the plugin or theme running too early. Translations should be loaded at the init action or later. Please see Debugging in WordPress for more information. (This message was added in version 6.7.0.) in /home1/wanrru6iyyto/public_html/wp-includes/functions.php on line 6114

Warning: Cannot modify header information - headers already sent by (output started at /home1/wanrru6iyyto/public_html/wp-includes/functions.php:6114) in /home1/wanrru6iyyto/public_html/wp-includes/rest-api/class-wp-rest-server.php on line 1893

Warning: Cannot modify header information - headers already sent by (output started at /home1/wanrru6iyyto/public_html/wp-includes/functions.php:6114) in /home1/wanrru6iyyto/public_html/wp-includes/rest-api/class-wp-rest-server.php on line 1893

Warning: Cannot modify header information - headers already sent by (output started at /home1/wanrru6iyyto/public_html/wp-includes/functions.php:6114) in /home1/wanrru6iyyto/public_html/wp-includes/rest-api/class-wp-rest-server.php on line 1893

Warning: Cannot modify header information - headers already sent by (output started at /home1/wanrru6iyyto/public_html/wp-includes/functions.php:6114) in /home1/wanrru6iyyto/public_html/wp-includes/rest-api/class-wp-rest-server.php on line 1893

Warning: Cannot modify header information - headers already sent by (output started at /home1/wanrru6iyyto/public_html/wp-includes/functions.php:6114) in /home1/wanrru6iyyto/public_html/wp-includes/rest-api/class-wp-rest-server.php on line 1893

Warning: Cannot modify header information - headers already sent by (output started at /home1/wanrru6iyyto/public_html/wp-includes/functions.php:6114) in /home1/wanrru6iyyto/public_html/wp-includes/rest-api/class-wp-rest-server.php on line 1893

Warning: Cannot modify header information - headers already sent by (output started at /home1/wanrru6iyyto/public_html/wp-includes/functions.php:6114) in /home1/wanrru6iyyto/public_html/wp-includes/rest-api/class-wp-rest-server.php on line 1893

Warning: Cannot modify header information - headers already sent by (output started at /home1/wanrru6iyyto/public_html/wp-includes/functions.php:6114) in /home1/wanrru6iyyto/public_html/wp-includes/rest-api/class-wp-rest-server.php on line 1893
{"id":7301,"date":"2017-09-23T19:22:32","date_gmt":"2017-09-23T19:22:32","guid":{"rendered":"https:\/\/businessecon.org\/?p=7301"},"modified":"2023-08-12T19:47:48","modified_gmt":"2023-08-12T19:47:48","slug":"working-capital-turnover","status":"publish","type":"post","link":"https:\/\/valueinvestingnow.com\/2017\/09\/working-capital-turnover","title":{"rendered":"Working Capital Turnover"},"content":{"rendered":"

Working Capital Turnover<\/span><\/strong><\/h1>\n

The activity ratios measure performance of a current asset<\/span><\/strong>\u00a0on the balance sheet against a corresponding area of the income statement. The working capital turnover is the most encompassing of all the activity ratios<\/span><\/strong><\/a>; in effect, it is the most general of the activity ratios. This particular ratio measures the ability of management to efficiently utilize net current assets. For those readers that don’t know or have forgotten, working capital<\/span><\/strong><\/a> is all gross current assets less <\/span>current liabilitie<\/span>s<\/span>. Working capital reflects the liquid position of the company; basically its ability to endure economic hardship. The more positive the working capital position, the greater the ability to weather financial storms or react quickly to opportunity.<\/span><\/p>\n

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.<\/span><\/p>\n

To prove its value and of course explain its flaws, this chapter will first explain the components of the formula.<\/span><\/p>\n

Working Capital Turnover Rate = Net Sales
\n<\/u>.<\/span> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Working Capital<\/span><\/p>\n

Then, it will also explain the relationship of the two components and why this ratio has merit. Next this article 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.<\/span><\/p>\n

Working Capital Turnover Formula<\/span><\/strong><\/h2>\n

The formula’s two components are net sales and working capital.The following subsections explain these two values in more detail.<\/span><\/p>\n

Net Sales<\/span><\/strong><\/h3>\n

Many accountants fail to understand that there is a difference between revenue and\u00a0s<\/a>ales<\/a>. 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<\/span><\/strong><\/a>.\u00a0 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\u00a0<\/em><\/strong>to relate sales to working capital. Net sales<\/span>\u00a0refines sales further to the net final amount actually sold.\u00a0<\/span><\/span><\/p>\n

Here is an example of the revenue section for identifying net sales.<\/span><\/p>\n

Revenue<\/strong>
\n<\/u>Gross Sales\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$ZZZ,ZZZ<\/span>
\n – Discounts\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0(ZZ,ZZZ)
\n<\/u>Adjusted Gross Sales\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0ZZZ,ZZZ<\/span>
\n Less:<\/span>
\n\u00a0 \u00a0 \u00a0– Returns\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 ($Z,ZZZ<\/span>
\n\u00a0 \u00a0 \u00a0– Allowances\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0(ZZ,ZZZ)
\n<\/u>Subtotal Returns & Allowances\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0(ZZ,ZZZ)
\n<\/u>Net Sales\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0ZZZ,ZZZ<\/span>
\n Other Revenue\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 ZZ,ZZZ<\/span>
\n Total Revenue\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$ZZZ,ZZZ<\/u><\/span><\/p>\n

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).<\/span><\/p>\n

Working Capital<\/span><\/strong><\/h3>\n

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.<\/span><\/p>\n

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.<\/span><\/p>\n

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<\/span>.<\/span><\/p>\n

Working Capital Turnover – Formula Analysis<\/span><\/strong><\/h2>\n

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). For simplicity, assume net sales are $5 Million and net working capital is $200,000. The result is a ratio of 25:1.<\/span><\/p>\n

Working Capital Turnover Rate = Net Sales<\/u>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 = $5,000,000<\/u>\u00a0 \u00a0=\u00a0\u00a0 25:1<\/span>
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Working Capital\u00a0 \u00a0 \u00a0 $200,000<\/span><\/p>\n

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:<\/span><\/p>\n

Working Capital Turnover Rate = Net Sales<\/u>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 = $5,000,000<\/u> \u00a0= 33.33:1
\n<\/u>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Working Capital\u00a0 \u00a0 \u00a0 $150,000<\/span><\/p>\n

Again, the formula is evaluating the ability to leverage assets. The higher the turnover rate, the better the leveraging of net current assets.<\/span><\/p>\n

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.). The higher the working capital, the more secure the business operation. Assuming sales is again $5,000,000 and working capital increases to $300,000, the working capital turnover rate decreases to 16.667:1.<\/span><\/p>\n

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.<\/span><\/p>\n

Which is better, a high working capital turnover or having more working capital?<\/span><\/p>\n

There is another factor that affects this formula. It is the working capital cycle<\/span><\/strong><\/a>. 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.<\/span><\/p>\n

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.<\/span><\/p>\n

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.<\/span><\/p>\n

Industry<\/u>\u00a0<\/strong>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0Characteristics<\/u><\/strong>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Reasonable Capital Turnover Rates<\/strong>
\n<\/u>Food Service\u00a0 \u00a0 \u00a0 High volume, low sales prices,\u00a0 \u00a0 \u00a0 \u00a0 \u00a0Reasonable working capital turnover ratios are<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0very low net working capital\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0between 4:1 and 15:1.\u00a0\u00a0Higher turnover rates<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0balances,\u00a0 leveraged with\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 indicate thin net working capital balances,\u00a0 too<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0leases\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0low and it is a sign of difficulty collecting<\/span>.
\n<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 amounts owed from customers (typically
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0accounts receivable w\/catering operations).\u00a0<\/span><\/span><\/p>\n

Transportation\u00a0 Steady sales and very high net\u00a0 \u00a0 \u00a0 \u00a0 \u00a0Expect turnover rates of 10:1, higher ratios<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0working capital balances for\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 are a really positive sign of controlling assets.<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0emergency purposes, a typical\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0hauler will have net working\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0capital > $100,000 for every\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$1,000,000 in sales.\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0<\/span><\/p>\n

Service\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Since this is a labor intensive\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Expect ratios greater than 35:1 and do<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0business and high sales volume,\u00a0 \u00a0 \u00a0 \u00a0 not be surprised at 100:1 ratio.<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0low net working capital balances\u00a0\u00a0<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0create very high capital turnover rates.\u00a0 \u00a0 \u00a0\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0<\/span><\/p>\n

Retail\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0High sales volume, high net\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Ideal ratios of 15:1 or greater;\u00a0 this is one<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0working capital balances;\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 of the industries where is very desirable to <\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 have very high ratios.<\/span><\/p>\n

Dealerships\u00a0 \u00a0 \u00a0 \u00a0 \u00a0Very low net working capital\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Dealerships have very high sales volume<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0balances as inventory is\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0in dollars on very low unit transactions.<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0customarily financed with\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0High sales volume with low net working capital<\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0floor plans (lines of credit)\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 balances create ratios of 100:1 or higher.\u00a0\u00a0It <\/span>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 is not unreasonable to see ratios of 200:1.<\/span><\/p>\n

Since the ratio is different for each industry, how exactly can an entrepreneur apply this ratio in evaluating a business?<\/span><\/p>\n

Working Capital Turnover Rate Application<\/span><\/strong><\/h2>\n

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:<\/span><\/p>\n

Broad Application<\/strong> – By comparing a sizable value of net sales against a netted amount from the balance sheet<\/span><\/strong><\/a> (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.<\/span><\/p>\n

Volatile<\/strong> – 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:<\/span><\/p>\n

\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Before<\/u>\u00a0<\/strong> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0<\/strong>After<\/strong>
\n<\/u>Net Sales \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$1,700,000 \u00a0 \u00a0 \u00a0$1,700,000<\/span>
\n Working Capital \u00a0 \u00a0 \u00a0$93,000<\/u>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0$111,600
\n<\/u>Ratio \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 18.3:1 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a015.2:1<\/span>
\n Change \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0(16.75%)<\/span><\/p>\n

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.<\/span><\/p>\n

No Real Discernible Information<\/strong> – 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.\u00a0<\/em><\/span><\/p>\n

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.<\/span><\/p>\n

With these inherent flaws, how can this ratio be used to help an investor or management with small business models?<\/span><\/p>\n

By their very nature, small businesses have thin or low working capital. This is true for several reasons:<\/span><\/p>\n

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.<\/span>
\n 2)\u00a0 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.<\/span>
\n 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.<\/span><\/p>\n

With a small denominator in the formula the resulting ratio is almost certainly guaranteed to be high. 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:<\/span><\/p>\n

.<\/span> \u00a0 \u00a0 \u00a0 <\/em>\u00a0<\/em>Rate<\/u><\/strong>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0<\/strong>Meaning and Investigation<\/strong>
\n<\/u>. \u00a0 \u00a0<\/em><\u00a0\u00a0\u00a0 10:1 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 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<\/span> 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\u00a0 equity,\u00a0 it is a sign of debt leverage so investigate the fixed assets to debt relationship. Low sales with negative profit is a serious problem.<\/span><\/span><\/p>\n

.<\/span> \u00a0 \u00a0\u00a0<\/em><\/strong>>\u00a0 10:1<30:1\u00a0\u00a0 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.\u00a0<\/em><\/strong><\/span><\/p>\n

. \u00a0 \u00a0 >\u00a0\u00a0 30:1 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0This 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.<\/span><\/p>\n

. \u00a0 \u00a0 >\u00a0 100:1\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Sales 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.<\/span><\/p>\n

Summary – Working Capital Turnover<\/span><\/strong><\/h2>\n

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:<\/span><\/p>\n

Working Capital Turnover Rate = Net Sales
\n<\/u>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Working Capital<\/span><\/p>\n

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. Lower working capital turnover rates are more appropriate for a small business which is counter-intuitive to business ratio application.<\/span><\/p>\n

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.<\/strong>\u00a0<\/span><\/p>\n