Your working capital (current assets minus current liabilities) represents your ability to meet short-term financial obligations, such as employee wages and payments to vendors.
A high working capital ratio lowers the likelihood that you are unable to pay your bills. But at the same time, you tie up cash, accounts receivable, and inventory – preventing your small business from investing in long-term growth opportunities.
With that in mind, you want to get your working capital to the “Goldilocks” zone.
Your working capital turnover ratio is a useful metric to determine if your working capital is just right.
In this article, you’ll learn:
- What working capital turnover is
- How to calculate it
- The idea ratio
- How to increase it
Definition
Working capital turnover measures sales against working capital.
Since working capital is the difference between current assets and current liabilities, this measure represents the financial resources needed to support sales.
Formula
Working capital turnover is calculated by taking net annual sales and dividing it by average working capital. It is sometimes referred to as sales to working capital ratio due to the way it is calculated.
Net annual sales is defined as gross sales minus returns, allowances, and discounts in a year. Average working capital = average current assets – average current liabilities.
Note: This measurement is only useful if your working capital is positive. If you have zero or negative working capital, this metric won’t give you a useful output.
Example
Over the previous 12 months, Company A recorded $1 million in net sales. Average working capital was $250,000 over the same period. Working capital turnover ratio is $1 million / $250,000 = 4.0. So, Company A is generating $4 of net sales for every dollar tied up in working capital.
What is the Ideal Working Capital Turnover?
In general, a high turnover ratio is preferable – assuming the company has no trouble meeting short-term financial obligations – as it shows that the company needs less working capital to support its sales.
What is ideal depends on your business, so it’s impossible to give a one-size fits all answer.
Let’s look at a few ways to help determine if your working capital turnover is good or bad:
- Do you struggle to meet your short-term financial obligations? If so, your ratio might be too high. If, on the other hand, you always have a lot of excess cash available, it might be too low.
- Are you constantly dealing with late payments from customers, leading to a build-up in accounts receivable? In this case, you are increasing your working capital without benefiting your small business – your working capital turnover might be below the optimal level.
- Look at your inventory turnover, which is your cost of goods sold (COGS) divided by average value of inventory. A high inventory turnover is a sign of strong sales, while a low inventory turnover might mean you have poor sales or too much inventory.
Here’s another way to assess your working capital turnover:
Compare your ratio to others in your industry (assuming their information is publicly available).
Look for a competitor of similar size, as the ideal working capital turnover for a $1 billion company is different from a $1 million company – even if they are in the same industry. The larger company may be able to secure better terms with suppliers and lenders, for example.
How to Increase Working Capital Turnover
The first step is identifying areas for improvement. You essentially want to decrease your current assets and/or increase your current liabilities… safely.
Let’s look at a few common areas of improvement:
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- Accounts receivable: negotiate favorable payment terms for your company. This might mean getting paid upfront or giving customers fewer days to settle invoices.
- Inventory: by optimizing your inventory management, you can potentially increase your working capital turnover.
- Accounts payable: in a perfect world, you can not only get paid faster by customers, but also take longer to pay vendors. See what’s possible – the worst case scenario is things stay the same.
Get Funding for Your Small Business
Many small business owners are constantly juggling the timing of payments to vendors and employees and from customers.
In some cases, a working capital loan can solve this problem – and optimize turnover.
Learn more about Gravity Payments’ quick and easy funding solutions.
