Working Capital Turnover Explained

Working capital turnover is a ratio between a company's working capital and its net sales over a given period. Usually, this period is a year. This ratio is used to determine how effectively the company uses its work force to generate sales. The higher the ratio, the more effective the company is. If the company is effective, it will earn more profit, and the investors will get bigger returns on their investments. If you have invested any of your money in a company, monitoring its working capital turnover will help you anticipate its profits and losses and change your investment strategy accordingly.

Understanding Working Capital Turnover

To understand how the working capital turnover works, you must first understand the variables involved. Working capital is the sum of money used to make products and/or sell them to the public. The net sales numbers represent the profit a company earned from selling its products. To keep the numbers consistent, both numbers are taken over the same period. Usually, that period is a year, but it may also be a month or several weeks.

Ideally, each company wants to earn as much profit from its products as possible while spending as little as possible. In reality, though, it can't afford to spend too little, or the quality of its products will suffer. This is why companies try instead to get the best value for their money. If a company spends lots of money to get a product out there, it better get several times as much money back.

This value is expressed using the working capital turnover ratio. The ratio takes the sum of the net sales and divides it by the working capital. For example, if the company's net sales are $14 million, and the company's working capital is $7 million, the company's working capital turnover is 7. The higher the company's working capital turnover is, the better value it gets for its money. If the number is 1, the company spends every dollar it earns in sales to recoup its production costs. While it's not losing money, it isn't profitable, either. If the number is less than 1, the company is spending more money on making products than it recoups by selling them. In other words, the company is suffering losses. Unless the company's ratio increases, its losses will accumulate, sending the company into a progressively negative financial situation.

Working Capital Turnover and Your Investments

As an investor, you want the company to make a profit. That way, the value of its stocks will rise, and you will get a bigger return on your investment. This is why it is in your best interest to keep an eye on the company's working capital turnover ratio and see how it changes over time. Keep in mind that just because the working capital turnover declines doesn't necessarily mean that you should stop investing in the company. The company executives see the same figures as you do, and they will try to take steps to address the problem. However, if the decline in working capital turnover persists, chances are pretty good that it's a sign of a deeper problem that will not be easily remedied. At that point, it may well be in your best interest to sell your stock and take your investments elsewhere.

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