Impacts of a Higher Working Capital Turnover Ratio on Your Business

The ratio, which shows how efficiently a company is utilising its working capital in relation to a specific amount of sales, is known as the working capital turnover ratio (WCTR).

You have to learn what working capital is and its importance before knowing the impact of a higher WCTR.

Working Capital (WC)

Every business needs funds to finance its short-term assets after paying off its short term liabilities. This fund is termed as working capital of a business. It helps in smooth functioning of the business while maintaining a uniform cash flow.

Importance of WC

Higher solvency: Efficient working capital management helps to ensure that the business has enough liquid assets like cash. This helps the business to increase production if a high demand situation arises.
Lower cost of capital: Managing working capital requirements using appropriate strategies help to reduce cost of capital while increasing returns.
Cushion shocks: Availability of adequate WC will ensure that the firm survives through unforeseen periods of crises. Therefore, a working capital loan can help your business in times of crisis.
Competitive edge: Business concerns that have a stable supply chain will be able to sell at a discount when the market is competitive. Therefore, a business loan for working capital is very helpful in competitive markets.

The ratio, which shows how efficiently a company is utilising its working capital in relation to a specific amount of sales, is known as the working capital turnover ratio (WCTR).

Working capital turnover ratio

WCTR is the ratio of net sales to average working capital. It is an accounting tool that helps to measure how well a company is utilising its working capital to support its annual sales. The formula can be represented in the following terms:

Working capital turnover ratio (WCTR) = Net sales / Average WC

Where,

Average WC = {(opening WC + Closing WC)/2}

Where,

Opening and Closing Working Capital (WC) = Current asset– Current liabilities

WCTR is measured for a specific period. This is because it signifies how many times a business has converted working capital into revenue.

Example:  

Let there be a firm called X Co. The firm has net annual sales of Rs. 12,00,000 and an average WC of Rs. 2,00,000.

By formula,

WCTR = Net annual sales / Average WC

= 12,00,000/2,00,000

= 6 times

Therefore, from the above workings, we can tell X Co. has converted its working capital into sales 6 times.

Working capital meaning and implications can be best understood when compared with industry standards. However, there are a few inferences that can be drawn from a high WCTR.

Implications of a high WCTR

1. In some cases like retail businesses, a high ratio implies that the business is not well financed and operations are running under shortage of funds.
2. In other businesses a high ratio is desirable, as it implies a higher degree of sales generated per unit of working capital employed.
3. It can also imply that among the different types of working capital policies, the manager has opted for aggressive financing policy.
4. If the ratio is too high, it can mean that the company is facing crisis of WC funds. If you think your business is running low on WC, you should opt for external funding to ensure continuous business operations.
5. In some cases, when the working capital turnover ratio gets too high, it is a certain indicator that the company is going to face insolvency very soon.
6. A high WCTR can also indicate that the firm is taking proper advantage of business opportunities and generation high annual sales volume. This is why working capital finance is necessary for small businesses.

Therefore, we can conclude that the management of working capital has significant impact on the performance of the business and a high working capital turnover ratio does not always mean a well-performing firm.

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