The Working Capital Turnover Ratio establishes a relationship between a firm's working capital and its sales (turnover). It measures how efficiently a company utilizes its working capital to generate revenue. A high ratio indicates that the company is effectively using its current assets and liabilities to support sales, meaning it generates a greater amount of sales for every rupee invested in working capital. On the other hand, a low ratio suggests that excessive working capital is employed relative to the level of sales generated, indicating inefficiency in utilization.
This ratio is an important activity ratio because it helps assess how efficiently a firm converts its resources into sales. Activity ratios are financial metrics used to evaluate a company's effectiveness in managing and utilizing its assets
The terms net sales, cost of goods sold and working capital can be defined as:
- Net Sales: This is defined as the average sales made by a firm during its operating cycle, excluding all kinds of returns, discounts and other allowances.
- Cost of Goods Sold: In practical cases, it might be hard to ascertain the net sales made by the firm. In such cases, the working capital turnover ratio is calculated using the cost of goods sold.
- Working Capital: It refers to the amount that can be readily used by a firm to manage its day-to-day activities. In other words, working capital depicts a company's ability to pay off its short-term obligations using its current assets.
Formula:
or
where,
Net Sales = Gross Revenue - Sales Return - Discount - Allowances or,
Net Sales = Cost of Goods Sold + Gross Profit
Cost of Goods Sold = Net Sales - Gross Profit or,
Cost of Goods Sold = Opening Inventory + Purchases - Closing Inventory
Working Capital = Current Assets - Current Liabilities
Significance:
It is extremely useful for the management, as it helps them ascertain the firm's ability to make use of its current resources in facilitating its turnover. A lower ratio implies that the sales generated are lower than they should be, considering the amount invested in the business by way of working capital. Hence, the management can take necessary steps in order to improve its sales and facilitate growth and development.
Illustration 1:
Compute the working capital turnover ratio from the following information:
Cost of goods sold ₹20,00,000; Gross Profit is
Solution:
Let net sales be ₹x.
Revenue from operations (Net Sales) = Cost of Goods Sold + Gross Profit
Working Capital = Current Assets - Current Liabilities
= ₹10,00,000 - ₹1,00,000
= ₹9,00,000
=
= 3.34:1 or 3.34 times
Illustration 2:
Compute the working capital turnover ratio from the following information:
- Cost of goods sold ₹30,00,000
- Gross Profit is 1/3rd of C.O.G.S
- Capital Employed ₹8,00,000
- Fixed Assets ₹1,00,000.
Solution:
Revenue from operations (Net Sales) = Cost of goods sold + Gross Profit
= ₹40,00,000
Since, Capital Employed = Fixed Assets + Working Capital
Working Capital = Capital Employed - Fixed Assets
= ₹8,00,000 - ₹1,00,000
= ₹ 7,00,000
=
= 5.71: 1 or 5.71 times
