Working capital turnover ratio

Working capital turnover ratio is computed by dividing the net sales by average working capital. It shows company’s efficiency in generating sales revenue using total working capital available in the business during a particular period of time.

Formula:

working-capital-turnover-ratio-img1

The formula consists of two components – net sales and average working capital. Net sales are equal to gross sales less any sales returned by customers during the period. Some analysts prefer to use cost of goods sold (COGS) rather than net sales as numerator of the formula. They argue that cost of goods sold has a more direct relation to the efficiency with which working capital is used in the business.

Working capital is equal to current assets minus current liabilities and average working capital is equal to working capital at the start of the period plus working capital at the end of the period divided by 2. The whole information for the computation of average working capital is available from the beginning and closing balance sheets.

Note for students: It is always preferable to use average working capital for the computation of working capital turnover ratio. However if only closing balances of current assets and current liabilities are known and beginning working capital cannot be determined, the working capital at the end of the period (closing working capital) may be used as denominator of the formula.

For more explanation consider the following example:

Example:

The following information has been extracted from Exide company:

Net sales: $300,000

Current assets on January 1, 2016: $240,000

Current assets on December 31, 2016: $280,000

Current liabilities on January 1, 2016: $140,000

Current liabilities on January 1, 2016: $100,000

Required: Compute working capital turnover ratio of Exide from the above information.

Solution:

= $300,000/$140,000*

= 2.14

*Average working capital:

[($240,000 – $140,000) + ($280,000 – $100,000)]/2

The working capital turnover ratio of Exide company is 2.14. It means each dollar invested in working capital has contributed $2.14 towards total sales revenue.

Interpretation:

Generally, a high working capital turnover ratio is better. A low ratio indicates inefficient utilization of working capital during the period. The ratio should be compared with the previous years’ ratio, competitors’ or industry’s average ratio to have a meaningful idea of the company’s efficiency in using its working capital.

The working capital turnover ratio should be carefully interpreted because a very high ratio may also be a sign of insufficient quantity of working capital in the business.

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3 Comments on Working capital turnover ratio

  1. Mercylin CG

    what is healthy working capital turnover ratio?

  2. Vikas yadav

    I don’t think that this formula is correct. I browsed some other websites also and found that these websites are using net sales or revenue instead of COGS. So, you may consider this once again.

  3. lalit

    yes, I have also seen in many books that instead of COGS there is using net sales or revenue from operation.

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