Working capital is the amount of money a company has for use in its daily operations. This figure is derived by subtracting a company's current liabilities from its current assets (calculated from their balance sheet). Working capital is further used in financial formulas such as the sales to working capital ratio, used to visualize how well a company uses its working capital.
The working capital turnover ratio is used to reveal if a company can support its sales growth with capital. To fully grasp what working capital is and what the ratios mean for an investor, you should compare it to businesses in the same industry with the same methods of operating and accounting practices; or, you could compare it to its past performances.
- Working capital is the amount of capital left over after subtracting current liabilities from current assets.
- The working capital turnover ratio uses net sales and average working capital to show if a company can support growth with capital.
- The sales to working capital ratio is a measurement of if there is enough cash in a business to support sales.
Compare Companies in the Same Industry
Although lower ratios are a good indicator, the optimal dollar amount of sales per dollar of working capital for a given firm depends on multiple factors, 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 a 1.1:1 ($1.10 working capital to $1.00 sales) ratio of working capital per dollar of sales.
Manufacturing companies might run a higher ratio, while service providers may not.
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 a candy business and nearly all candy manufacturers are between $10 and $15 working capital per dollar of sales and you come upon a potential investment that has much less or more than 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.
Sales to Working Capital Ratio
Many investing analysts use the sales to working capital ratio to help them valuate a stock. You'll also find it referred to as working capital percent of sales and working capital per dollar of sales. In this method, you take the difference of the current assets and liabilities, to get working capital, and then divide working capital by gross sales. The information you need is on a company's balance sheet, income statement, or somewhere in the form 10-k filed with the Securities and Exchange Commission:
Sales to Working Capital Ratio = Net Sales ÷ ( Current Assets - Current Liabilities )
Working Capital Turnover
The necessary elements to do the calculation can be found on the balance sheet and income statement. You'll first need to calculate the average working capital for the period by using the values for the beginning and end of the current period:
- Beginning of period (b)—this is usually the working capital at the end of the last period
- End of period (e)
Calculate the working capital for the beginning and end of the period, if necessary (some balance sheets report it, so you may not need to calculate it):
Working Capitalb = Current Assetsb - Current Liabilitiesb
Working Capitale = Current Assetse - Current Liabilitiese
Then, average the two:
Average Working Capital = ( Working Capitalb + Working Capitale ) ÷ 2
Once you have the average working capital, you reference the income statement and use net sales. Net sales can be reported on the income statement, or in the company's form 10-k; if it isn't, it can be calculated:
Net Sales = Total Revenue - ( Cost of Sales Returns + Allowances + Discounts )
You then calculate the turnover ratio:
Working Capital Turnover = Net Sales ÷ Average Working Capital
If the result is too high, e.g., more than a ratio of 1:1, the company you are analyzing might be having trouble converting inventory to sales, or not enforcing proper collection policies on their accounts receivable.
A Working Example
As an example, look at the 2018 annual report for Johnson & Johnson, and calculate the working capital turnover for it.
First, you calculate working capital. You pull the firm's 10-K filing and see that current assets were $46 billion and current liabilities were $31.2 billion. This leaves a working capital for the end of the 2018 period of $14.8 billion.
Current assets for the year ending 2017 were $43 billion, with current liabilities of $30.5 billion. You now have the beginning working capital for 2018, $12.5 billion.
Next, you can find the net sales information hidden in the 10-k, in the sections labeled for different customer segments—consumer, pharmaceutical, and medical. For 2018, total returns equaled just over $8 billion.
Working Capital Turnover = $8 billion ÷ [ ($14.8 billion + $12.5 billion) ÷ 2 ]
The working capital turnover ratio for 2018 was .58, or $.58 for every $1.00 dollar of sales.