Average Working Capital: Everything You Need to Know
Average working capital is a measure of a company's short-term financial health and its operational efficiency.3 min read
2. Understanding the Working Capital Ratio
3. Inefficient Use of Working Capital
4. Working Capital Turnover
5. Effects of Low Working Capital Turnover
6. Impact of a High Working Capital Turnover Ratio
Average working capital is a measure of a company's short-term financial health and its operational efficiency. It is calculated by subtracting current liabilities from current assets.
Calculating Average Working Capital
A good example of a liability is accounts payable. Examples of assets are:
- Inventories of finished good and raw materials.
- Accounts receivable.
Current assets divided by current liabilities is known as a working capital ratio. To calculate a company's average working capital, the following formula is used:
(Working capital of the current year + Working capital of the prior year) ÷ 2
This indicates whether a company possesses enough short-term assets to cover short-term debt.
Understanding the Working Capital Ratio
Any point between 1.2 and 2.0 is considered a good working capital ratio. If the ratio is less than 1.0, it is known as negative working capital and indicates liquidity problems. A ratio above 2.0 may indicate that the company is not effectively using its assets to generate the maximum level of revenue possible.
A working capital ratio that continues to decline is a major cause of concern and a red flag for financial analysts. Alternatively, they may consider the quick ratio which is used to indicate short-term liquidity because it includes account receivables, cash, cash equivalents, and marketable investments.
Inefficient Use of Working Capital
Most business undertakings require a working capital investment. Although this reduces cash flow, it should be balanced out by money coming in via account receivables. However, if payment is being collected slowly, or there is a decrease in sales volume leading to reduced account receivables, the resultant effect is reduced cash flow.
Businesses that inefficiently use their working capital can increase cash flow by squeezing customers and suppliers or selling off assets.
If your working capital ratio is high, it is not necessarily a good thing because it indicates that your business isn't investing excess cash or has too much inventory.
Working Capital Turnover
The working capital turnover is the ratio that helps to measure a company's efficiency in using its working capital to support sales. This ratio is also known as net sales to working capital and shows the relationship between the revenue generated by the company and the funds needed to generate this revenue.
Calculating this ratio involves dividing annual sales by average working capital, then subtracting this figure from the difference between current assets and current liabilities within a 12-month period.
For instance, Company X has net sales of $10 million in a 12-month period and had an average working capital of $2 million within that same period.
Working capital turnover ratio is $10,000,000/$2,000,000 = 5
Since the turnover ratio is high, it shows that the company's management is effective in utilizing the company's short-term liabilities and assets to support sales.
Effects of Low Working Capital Turnover
A low ratio could mean that the company invests too much in inventory and account receivables, which may, in turn, result in obsolete inventory and excessive debt.
To ensure that they are using their working capital efficiently, businesses should effectively manage accounts payable, accounts receivable, and inventory levels. Inventory turnover determines the frequency of sales and replacement of inventory within a given time period; the receivables turnover ratio indicates the business's ability in collecting debt from debtors and extending credit to customers.
Impact of a High Working Capital Turnover Ratio
If the working capital turnover ratio is high, it means that the business is running smoothly and requires little or no additional funding to continue operations. It also means that there is robust cash flow, ensuring that the business has the flexibility to spend capital on inventory or expansion.
A high working capital turnover ratio also gives the company an edge over its competitors. However, if the ratio is extremely high — over 80 percent — it could mean that the business doesn't have enough capital to support expansion and sales growth. A very high ratio also indicates that the business is very likely to become insolvent in the near future. This is especially true if the accounts payable is high since it indicates the business's difficulty in paying its suppliers and creditors.
To spot an extremely high turnover ratio, you need to compare the ratio for your company with other businesses in the same industry and scale.
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