The working capital turnover ratio of a company is used to determine how the company is generating sales with respect to its working capital. It signifies the number of net sales generated for every single unit of working capital involved in the business.
A high amount of working capital indicates that the current assets of a company are considerably higher than the liabilities. Companies perform different types of analysis to determine if the working capital is being utilized properly.
Working capital
Working capital is the difference
between a company’s current assets and its liabilities. It is the measure of a
company’s short-term financial health. If a company’s accounts receivable does
not exceed the accounts payable, then it may have problems paying off the
creditors and can lead to bankruptcy.
How to calculate working capital turnover ratio
Working capital turnover can be determined by using the simple formulae:
Working capital turnover = Net annual sales/ Average working capital.
Suppose, a company has a net sales of Rs. 10 lakhs over the past 12 months, and the average working capital is Rs. 2 lakh. Then the ratio will be Rs. 10, 00000/ Rs. 2, 00000 = 5.
A high turnover ratio indicates that
the company is efficiently using its short term assets and liabilities to
support sales. On the other hand, a low turnover ratio indicates that the
company has too many liabilities which can eventually increase the number of
bad debts and obsolete inventory.
High working capital turnover
A high working capital turnover indicates that a company is running smoothly and does not need any additional funding. It implies that funds are coming in and flowing out on a regular basis, giving the company an opportunity to expand the business and inventory with the capital.
A very high ratio usually over 80%
may indicate that a company does not have enough capital to support its sales
growth. Companies can take a working capital loan from different financial institutions
to expand their business and support the growth in sales.
Improve the turnover ratio by managing your working capital
A high working capital turnover ratio can be achieved by implementing the following steps to manage the working capital –
- Provide incentives on receivables
Providing incentives to customers who pay on time will help in increasing the working capital. Customers are more likely to complete the payments on time if they receive incentives for doing so. It will maintain the continuous flow of funds and provide enough working capital in case of expansion.
- Proper inventory management
Excessive stock in the inventory can clog surplus funds. Overbuying frequently can affect the working capital and subsequently reduce the turnover ratio. It is very crucial to have monthly or quarterly stock audit so the inventory is not overstocked.
- Paying debts on time
Working capital can be managed by paying off the debts in time. Timely payments will reduce such scenarios that may attract penalty and reduce the working capital.
- Availing loans for a short-term solution.
Knowing all about several working capital loan FAQs can be an excellent way to overcome any shortfalls in the funds. A company can take such a loan to expand the business which can boost sales and increase the turnover ratio.
Let’s now have a look what is the importance of proper working capital management and what are its objective:
Here are some important points to highlight why working capital management is important for businesses:
- Increasing Profitability
- Better Liquidity
- Ensuring Higher Capital Return
- Improving Solvency and Credit Profile
- Business Value Appreciation
- Taking Advantage over Competitors
- Interruption Free Productivity
- Making a Business Ready for Peak Demands
What are the Objectives of Working Capital Management
According to a research report on working capital management, the following are its main objectives:
- Effortless Operating Cycle: The working capital management’s main objective is to ensure the company’s effortless operating cycle. This means the work cycle must never stop due to lack of liquidity, whether it’s for salaries, buying raw materials, tax payments or other finances.
- Minimize Cost of Capital or Interest Rate: It is essential to understand that the cost of the capital’s interest is one of the important costs in any company. A company’s management must negotiate well with their financial institutions for selecting the right financing mode while maintaining its optimal capital structure.
- Optimal Return Rate When Investing in Current Assets: When running a business, one must have a liquidity crunch at one end and excess liquidity, on the other. During the time of excess liquidity, the working capital management must have better short-term investments for taking advantage of the idle funds.
- Keep Working Capital at Lowest: To keep the working capital turnover ratio at its lowest, it is necessary to acquire favorable credit terms through accounts payable and receivables, effective inventory management, faster production cycle, etc.
Increasing the working capital by implementing the above-mentioned methods can help to achieve a high working capital turnover ratio. It is very important to maintain a high ratio to ensure the smooth running of any business. Learn more here