Calculation Of The Working Capital: Easy Steps & Formulas

Working capital is a financial metric helping businesses measure their short-term financial health. The calculation of the working capital starts by subtracting current liabilities from assets and then dividing net sales by the working capital.

The working capital turnover ratio shows how efficiently a company uses its funds to keep the business running. It helps to understand if the company can manage its financial needs smoothly.

This ratio is important for investors and business managers as it helps them see if the company can grow and stay profitable with its available resources.

Understanding the Working Capital Turnover Ratio

The working capital turnover ratio meaning is important to know, especially when you run a business. It measures how efficiently a company uses its funds to generate revenue. The calculation of the working capital turnover ratio is done with simple formulas:

🔹 Working Capital = Current Assets – Current Liabilities
🔹Working Capital Turnover Ratio = Net Sales / Working Capital

However, the formula for working capital ratio can be adjusted depending on the current values. A low ratio indicates poor financial management, lower liquidity, and potential risk of bankruptcy. A high ratio (ideally between 1.5 to 2) means the company efficiently uses its funds to manage operations and growth. However, a ratio above 3 suggests underutilised capital, which may cause future financial challenges.

By analysing this ratio, businesses and investors can assess a company’s ability to maintain smooth operations and long-term profitability.

Example of Working Capital Turnover Calculation

Let us assume that a company XYZ values its current assets as ₹6 lakhs, current liabilities as ₹3 lakhs and net sales as ₹5 lakhs. Using the working capital method:

Working Capital Formula = Current Assets – Current Liabilities 

= ₹6,00,000 – ₹3,00,000

= ₹3,00,000

To know how to calculate working capital turnover ratio, we must divide the working capital by the net sales of ₹5 lakhs. 

Working Capital Turnover = Working Capital / Net Sales

​ = ₹5,00,000/₹3,00,000

=1.67

The working capital turnover ratio for XYZ company is 1.67, which is excellent. 

Advantages of Working Capital Turnover Ratio

By calculating this ratio, a company can understand its financial status and compare it against the market. Some other advantages include:

• Helps a company assess how efficiently it uses funds for sales and operations
• Enables comparison of past and current performance to identify trends
• Improves decision-making on working capital, inventory and payments
• Evaluates daily operations to track growth and financial stability

Also Read: Working Capital Cycle

Limitations of Working Capital Turnover Ratio

Other than the benefits of this calculation, you can come across some limitations as well. This can include overlooking important details and temporary fluctuations.

• One limitation of this ratio calculation is that it provides a very narrow insight into the company. It does not focus on the profitability of the business model. 
• This ratio calculation varies across different industries and regions. Sometimes, this calculation can be misleading for companies due to the sector in which they operate. 
• Solely focusing on this ratio and ignoring other important data can lead to mistaken conclusions for the company. Since a company’s financials can fluctuate over time, the ratio may change, which makes it less reliable in the short term.

Since the working capital turnover ratio shows how well a company uses its funds, a lower ratio could mean overspending or poor financial management. To keep it on track, you need to manage your funds wisely.

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FAQs on Working Capital Turnover Ratio

What is a good working capital ratio?

A good working capital turnover ratio can range between 1.5 and 2. A ratio less than 1 depicts liquidity issues, whereas a ratio above 3 indicates the company is not using the funds efficiently. 

What is the net working capital ratio?

It is a financial metric used by companies to assess their current financial standing. They use the formula: Current assets – Current liabilities and then Working Capital / Net Sales to arrive at a ratio. 

Is a high NWC good?

No. A higher net working capital of more than 3 indicates that a company is not using the funds efficiently for future growth. The ideal ratio should remain between 1.5 and 2. 

What is the formula for the net working capital ratio?

The formula for the net working capital ratio is Current Assets / Current Liabilities.