Why Do We Calculate The Working Capital Turnover Ratio?

14 May 2022

Why Do We Calculate The Working Capital Turnover Ratio?

We calculate the working capital turnover ratio for a business to compare how much money the business is using to the sales being generated. In general, a business that is healthy and performing well will have a high turnover working capital ratio, meaning they are using its assets efficiently to generate more sales.

As with most things, though, there is a lot of nuance to understanding all of the factors that go into a working capital turnover ratio. Let’s go through all the elements that a business would want to consider in its working capital turnover ratio interpretation and calculation.

What Is Capital Turnover Ratio?

This ratio shows the relationship between how much money a business spends and how much they bring in via sales. Another way to think of this working capital ratio is the difference between how much it costs to run the company and how much the company makes. You’ll sometimes hear it referred to as “for every $1 we invested, we made $6 back,” which would indicate a capital turnover ratio of 6/1 or 6.

The reason this calculation is called a turnover ratio is that it looks at how many times the working capital of a business is “turned over,” or used again, to generate sales in a given year. If you have $1 in working capital and make $6 in a year, you turned over that $1 six times. In this case, that $1 is working harder than $1 in a company that generated $4. That $1 only turned over four times." Basically, your capital turnover ratio shows how often your revenue comes back into your pocket after you spend it.

How Do You Calculate Working Capital Turnover Ratio?

The working capital ratio formula is net annual sales divided by working capital. 

Net Annual Sales / Working Capital = Working Capital Turnover Ratio

Since this formula can still be hard to understand when looking at a real-world example, let’s break it down and look at how to calculate the working capital turnover ratio from a balance sheet.

  • net annual sales = gross sales minus (returns, discounts, allowances)

  • working capital = current assets minus current liabilities 

Let’s look at a working capital turnover ratio example to make this formula even clearer. If we look at Mcdonalds' K-10 report for 2021 (source) we find that:

  • Net Annual Sales = $23,223 million 

  • Working Capital = $18,231 million  ($53,854 million in assets - $35,623 million in liabilities)

    • current assets = $53,854 million

    • current liabilities = $35,623 million

  • Turnover Ratio = $23,223 / $18, 231 = 1.27 

In this example, the working capital turnover ratio is 1.27. This means that for every $1 McDonald’s spent, they generated $1.27 in sales. 

What Is a Good Working Capital Turnover Ratio?

A good working capital turnover ratio varies widely by industry. Generally, a good working capital ratio is one that is slightly higher than your competitors in the same industry. So if your nearest competitors have working capital turnover ratios of 1.1, 1.2, and 1.3 and your ratio is 1.27, your company is generally considered to be positioned well in the industry. 

A slightly higher-than-average ratio is considered good because it indicates that a business is using its invested capital efficiently to generate sales compared to the competition. This suggests a business is well-positioned to continue to grow and leverage its capital to stay competitive in the future. 

Working Capital to Sales Ratio by Industry

For businesses like McDonald's or others that sell lots of inexpensive products and go through inventory quickly, low turnover ratios (between 1.1 and 2.0) are common. 

For businesses that sell services rather than physical items, a higher turnover ratio (between 2.0 and 10.0) would be expected. This higher ratio would be common for these types of businesses because they do not have as much physical inventory as part of their operations, meaning their working capital is likely lower.

Because there can be such a wide range of working capital turnover ratios within and between industries, looking at direct competitors in your field will be the best way to get an accurate view of how your company stacks up. This can be calculated for publicly traded companies from their Consolidated Statements of Operations which are available through the US Securities and Exchanges Commissions EDGAR search.

What Indicates a Bad Working Capital to Sales Ratio?

Although a slightly higher than the industry average ratio often means your company is using its working capital efficiently to drive sales, there are some occasions when this ratio can get too high. If your industry has a standard working capital turnover ratio of around 7 and your company’s ratio is 51, something is likely to happen that should cause concern. 

The most common issue faced by a company with an extremely high working capital ratio is not enough working capital. If a company needs to cycle through its working capital 51 times a year to generate annual sales, there’s not a lot of wiggle room for financial fluctuations. Very high ratios often mean a company is struggling to generate enough working capital to consistently pay its bills as they come due, and would likely benefit from additional working capital to stabilize its finances.

A Working Capital Increase from Backd Can Help!

Businesses go through all kinds of things that might make their financial ratios less than ideal for reaching their goals. Don’t let a lack of working capital stop you from generating the sales and growth your business can have! 

We at Backd are passionate about supporting small businesses, so we’ve designed our funding to suit actual small business needs. With lending options from $20,000 - $2M and terms up to 14 months, you can get the working capital you need on a timeline that works for you. Our application process takes 10 minutes or less and once you’re approved, you can get the money your company needs within three days! If that sounds good, apply today or contact us for more information on how we can help your business!