Every business owner needs to have a grip on the basic financial ratios to effectively manage their so-called finance department. The Capital Turnover Ratio is one such ratio that can significantly help determine a company’s operational efficiency.
The Capital Turnover Ratio, also known as the Working Capital Turnover Ratio, is an essential financial ratio that determines how efficiently a company’s working capital is being used to generate revenues. It’s a crucial measure that helps the management cope with any crisis, make decisions about improvements, and ensure the growth of the organization in the future.
In simple words, the Capital Turnover Ratio measures the company’s annual working capital requirement, i.e., how much capital the business requires to function effectively every year. Furthermore, it also evaluates how efficiently a company can generate sales revenue from its working capital.
Calculating Working Capital Turnover Ratio
This ratio is calculated by dividing sales revenue by working capital. Working capital is defined as the capital required by a company to function effectively, which is calculated by deducting current liabilities from current assets.
The Formula For Calculating Working Capital Turnover Ratio is:
Working Capital Turnover Ratio = Annual Sales Revenue / Working Capital
The annual sales revenue can be found on the income statement, also known as the Profit and Loss statement.
The working capital may vary over time, but it is essential to calculate it annually to understand whether the company is utilizing its working capital effectively to generate sales revenue.
Example
Let us consider an example to understand how to calculate the Working Capital Turnover Ratio.
Suppose a business has:
Annual Sales Revenue = Rs. 500,000
Current Assets = Rs. 300,000
Current Liabilities = Rs. 100,000
Working Capital = Current Assets – Current Liabilities = 300,000 – 100,000 = Rs. 200,000
Therefore, the Working Capital Turnover Ratio for this business can be calculated as:
Working Capital Turnover Ratio = Annual Sales Revenue / Working Capital
= 500,000 / 200,000
= 2.5
This ratio indicates that the business generated Rs. 2.5 in revenue for every Rs. 1 invested in working capital.
Working Capital Turnover Ratio Interpretation
The goal of every business is to achieve a higher Working Capital Turnover Ratio. This ratio indicates whether the business is effectively utilizing its working capital to generate revenue or not. The higher the ratio, the better it is for the business. For instance, a ratio of 2.5 means that the business can generate Rs. 2.5 in sales revenue for every Rs. 1 invested in working capital.
In contrast, a lower Working Capital Turnover Ratio indicates that the business is inefficiently using its working capital to generate sales revenue, which means the company is at risk of pitfalls in the long run.
The Working Capital Turnover Ratio can help in assessing whether the company needs to:
increase working capital to generate better sales revenue, or,
decrease working capital and optimize other aspects of the business to compliment sales revenue.
Working Capital Turnover Ratio and Its Importance in Finance
The Capital Turnover Ratio is an important financial ratio, especially when it comes to analyzing the company’s financial performance. It helps financial analysts to assess the company’s operational efficiency and liquidity. This information is especially important for investors and creditors, who use this ratio to assess the company’s financial health, risk factors and to determine whether or not to make investments in the company.
The Working Capital Turnover Ratio provides valuable insights into the company’s performance for lenders to determine whether they should extend credit to the business or not. This ratio serves as a benchmark to comprehend the financial standing of the company. Additionally, this ratio helps businesses in managing their working capital effectively, which ultimately leads to more revenue generation.
Conclusion
In conclusion, the Working Capital Turnover Ratio is an essential financial measure that determines how efficiently the working capital of a company is being used to generate revenue. This ratio helps businesses to assess the effectiveness of their operations, make decisions to improve the operations, and attract funding opportunities from investors and creditors. It is vital for businesses to calculate this ratio regularly to assess their operational performance, learn from the insights, and make investment decisions accordingly.
