Working Capital Per Dollar of Sales and Turnover Ratio
Investing Lesson 3 - Analyzing a Balance Sheet
Now that you know what working capital is, the question becomes, "How much working capital should a company have on its balance sheet?"
The answer, and metric, is often expressed as a financial ratio known as working capital per dollar of sales. The calculation itself is straightforward. You take total revenue and divide it into the working capital of a firm.
Precisely how much working capital per dollar of sales is optimal for a given firm will depend on multiple things, including the industry and sector in which the business operates. A business that sells a lot of low-cost items and cycles through its inventory rapidly (such as a convenience store, grocery store, or discount retailer) may only need 10-15% of working capital per dollar of sales.
A manufacturer of heavy machinery and high-priced items with a slower inventory turn may require 20-25% working capital per dollar of sales. A company such as Coca-Cola would probably fall somewhere between the two.
Generally, the best way to determine the range in which a particular company should fall is to compare it to its competitors. If you're looking at the candy business and nearly all candy manufacturers are between [x] and [y] working capital per dollar of sales and you come upon a potential investment that has 1/3rd or 4x that amount, it should raise your eyebrows and warrant further investigation, because the odds are high that there is something going on you need to understand.
Calculating Working Capital Per Dollar of Sales
Here's the formula for Working Capital per Dollar of Sales:
A few real-world examples should help you understand the concept better.
Practice Sample Working Capital Per Dollar of Sales Calculation I
The first calculation we'll do comes from an old annual report of Goodrich. It was the original example I used when I first wrote this lesson more than 15 years ago and that I'm retaining it for the sake of nostalgia.
First, we calculate working capital, which came to $933 million. Next, we looked for total sales on the income statement, which was $4.3 billion. Finally, we plug them into the working capital as a percentage of revenue formula:
Working Capital of $933 million ÷ Total Sales of $4.3 billion = .2138, or 21.38%
As a manufacturer of heavy duty machinery, Goodrich fell within the 20-25% working capital per dollar of sales range that was typical for its peers; a good showing that cast it in a favorable light.
Practice Sample Working Capital Per Dollar of Sales Calculation II
Now, let's look at a recent annual report for another business, Johnson & Johnson, and calculate the working capital per dollar of sales for it. Even though it's January 30th, 2016 at the time I'm writing this, the full year 2015 figures haven't been released, yet, so we'll go back to the 2014 financial statements.
First, we calculate working capital. We pull the firm's 10-K filing and see that current assets were $59.3 billion and current liabilities $25.1 billion. This leaves working capital of $34.2 billion.
Next, we look at the income statement and find total sales came to $74.3 billion for the year.
Now, we combine the two into the working capital per dollar of sales calculation:
$34.2 billion working capital ÷ $74.3 billion sales = .46, or 46% working capital per dollar of sales.
Some Analysts Prefer to Invert Working Capital Per Dollar of Sales Into a Financial Metric Known as Working Capital Turnover
Another way to express what we've just calculated is working capital turnover. To calculate it, you take the working capital per dollar of sales and divide it into one. For example, in the case of Johnson & Johnson, you'd take 1 ÷ .46 to arrive at 2.17.
You can reverse engineer the working capital turnover ratio back into working capital per dollar of sales by taking it and divide it into 1. For example, in this case, you'd take 1 ÷ 2.17 and get .46, or 46%.