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The working capital and turnover measurements are used by operations managers to track the efficiency of the operations. 

Quick reference

Working Capital Measurements

The working capital and turnover measurements indicate business operations efficiency. 

When to Use Working Capital Measurements

These measures are normally used by operations managers to track the efficiency of the operations.  Most organizations that use these measures update them either weekly or monthly.

Instructions

  • Many operational measures and accounts are turned into “turnover” ratios.  This means the account is divided into the most recent 12 months of sales.  The ratio shows how many times the account “turns over” during the course of the year.  The higher the ratio the better, since it shows that the business is taking its assets and turning them into sales.
  • Working capital is a measure of how well the operations management team is running the business. 
  • Working capital is the difference between current assets and current liabilities.  The primary components of current assets are cash and equivalents, accounts receivable and inventory.  The primary components of current liabilities are accounts payable and short term debt.
  • A working capital value that is negative indicates the business may not be able to pay its bills.
  • Working capital is sometime shown as the working capital ratio which is the current assets divided by the current liabilities.   This allows investors and managers to compare business units with very different magnitude of operations for efficiency.  Generally a value greater than 1.5 is good.   However, a value that is too high could indicate that excessive inventory or receivables were accumulating.  A working capital ratio that is less than 1 indicates the business may not be able to pay its bills.
  • Working capital is often turned into a ratio known as working capital turnover by dividing it into the most recent 12 months of sales.  This ratio makes no sense if the working capital nears zero or goes negative.  The higher the working turnover, the better the business efficiency.  Working capital turnover ratios can be increased by increasing sales without increasing working capital or decreasing inventory and receivables without reducing sales.
  • There are two variations on the working capital turnover ratio that do a turnover ratio with only one of the working capital elements.  These two ratios are inventory turnover and receivables turnover.
  • Inventory turnover takes the most recent 12 months of sales and divides it by the value of the inventory on hand.  The higher the ratio, the better the company has been able to turn inventory into sales.
    • A variation on this ratio uses the past 12 months of Cost of Goods Sold (COGS) instead of sales.  This removes the effect of pricing and ensures that the ratio is just “inventory sold” over “inventory on hand.” 
  • Receivables turnover takes the most recent 12 months of sales and divides it by the value of Accounts Receivable.   The higher the ratio the better the company has been able to convert sales into cash.
  • Both inventory turnover and receivables turnover are sometime expressed in units of “days.”  This is done by dividing the turnover value into 365 days.  This represents how many days are required for the inventory to be sold and replaced or for the receivables to be collected.  With these measures, the smaller the number the better.

Hints and Tips

  • Working capital is tricky.  Both too high and too low are problems.  Most manufacturing companies set a target that is a working capital ratio between 1.5 and 2.5.  However, your business may be working to a different target depending upon its strategy.
  • When turnover is expressed as a ratio, the higher the value the better.  When turnover is expressed in days, the lower the value the better.
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  • 00:03 Hi, I'm Ray Sheen.
  • 00:04 I'd now like to introduce the concept of working capital and
  • 00:07 the efficiency measurements that are related to working capital.
  • 00:11 Let's start with working capital.
  • 00:14 This measure is based upon values found on the balance sheet.
  • 00:18 So this means it is for a point in time.
  • 00:20 Working capital is defined as current assets minus current liabilities.
  • 00:24 These are both easy to find on the balance sheet.
  • 00:26 The working capital ratio is the ratio of current assets over current liabilities.
  • 00:31 This ratio is often used for comparison between companies of very different scale.
  • 00:36 In well-run companies, the working capital ratio would be similar,
  • 00:39 whether they did 10 million in annual sales or 10 billion in annual sales.
  • 00:44 Whether looking at working capital as a value or a ratio, all we are seeing is
  • 00:49 an efficiency measure indicating how well the business is being managed.
  • 00:53 A negative working capital, or a ratio less than 1,
  • 00:56 would indicate a company that may have trouble paying its bills.
  • 00:59 There are not enough current assets to meet the current liabilities.
  • 01:03 By the same token, if the ratio is much greater than 1, the company may have
  • 01:06 an efficiency problem with too much inventory and too many receivables.
  • 01:10 A good rule of thumb is that a company that is run efficiently will
  • 01:14 have a ratio between 1.5 and 2.5.
  • 01:17 That does vary quite a bit from industry to industry, so
  • 01:19 check with your finance team to find out which target your company uses.
  • 01:24 Let's look at the term turnover.
  • 01:26 This term is used several different ways in the financial world,
  • 01:29 which can lead to confusion.
  • 01:31 We'll discuss it in the context of efficiency.
  • 01:33 Turnover ratios compare sales to an operational measure.
  • 01:37 So while working capital is for
  • 01:39 a point in time, it is often combined with the sales value for
  • 01:42 the preceding 12 months to create the turnover ratio, working capital turnover.
  • 01:47 This value is often updated monthly, with a new value of working capital and
  • 01:51 the most recent 12 months of sales.
  • 01:53 Generally speaking,
  • 01:54 the higher the working capital turnover, the more efficient the operation.
  • 01:58 However, a caution with that.
  • 02:00 When working capital approaches 0, the turnover value will go through the roof.
  • 02:04 That sounds good,
  • 02:05 but remember, working capital indicates whether we can pay the bills.
  • 02:09 So a working capital of 0 is very risky.
  • 02:11 Since working capital turnover is a measure of efficiency,
  • 02:15 it should increase if we become more efficient.
  • 02:17 Let's check it out.
  • 02:18 If I increase my sales without increasing any of my costs or
  • 02:21 inventory, I have become more efficient.
  • 02:24 In that case, the sales go up, the working capital stays the same, so
  • 02:27 the measure increases.
  • 02:29 By the same token, if I keep my sales constant but reduce my inventory and
  • 02:33 accounts receivable, I become more efficient.
  • 02:36 In that case, the value for 12 months of sales is constant, but
  • 02:40 working capital goes down, and the working capital turnover ratio goes up.
  • 02:45 Many companies will take their working capital turnover ratio and
  • 02:48 essentially break it apart to focus on two key operational measures, inventory and
  • 02:52 receivables.
  • 02:53 Let's look at inventory turnover.
  • 02:56 As we have stated,
  • 02:56 turnover measures look at sales compared to an operational measure.
  • 03:01 Inventory turnover is the ratio of the last 12 months of sales
  • 03:04 over the value of inventory on the balance sheet.
  • 03:07 Now, this value of sales has other effects besides the number of units sold.
  • 03:11 It also has sales price and sales discounts.
  • 03:15 These can sometimes mask any effects going on with inventory, so
  • 03:18 many companies choose to do their inventory turnover calculation
  • 03:22 using the last 12 months of COGS.
  • 03:24 That way the ratio is inventory over inventory.
  • 03:27 This value of inventory turnover is essentially telling us how many times
  • 03:31 the inventory turns over in the factory during the course of a year.
  • 03:36 Depending upon your industry,
  • 03:38 a well run company could have a value anywhere from 3 to 30.
  • 03:41 The higher the value, the more efficient the manufacturing and
  • 03:44 logistic side of the business.
  • 03:46 Many companies will divide the number into 365 to determine the average number of
  • 03:50 days that inventory is in the pipeline.
  • 03:53 Of course, in this case, the smaller the number the number, the better.
  • 03:57 Just as we did with inventory turnover, we can do a similar set of calculations with
  • 04:01 accounts receivables, to create receivables turnover.
  • 04:05 Turnover ratios compare 12 months of sales and operating measures.
  • 04:09 This turnover ratio will use the value of the accounts receivable.
  • 04:13 This is showing the efficiency of the business in its collections.
  • 04:16 Often, this is also an indication of whether the sales process went smoothly,
  • 04:19 or if instead there are customer complaints and customers refusing to pay.
  • 04:23 Like with inventory turnover, a high value is good.
  • 04:26 It means the customers are paying us in a timely manner.
  • 04:30 And, like with inventory turnover, the value can be be divided into 365 to
  • 04:35 determine the average number of days the company waits before it is paid.
  • 04:41 Turnover measures are great efficiency measures, and
  • 04:44 converting them into days is an excellent way to communicate both the targets and
  • 04:48 current performance to operational people.

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