What is the working capital turnover ratio and why is it important?
In the world of startups and SaaS business, there are several markers a company can look to in order to determine how successful it is. One of these indicators is a company’s working capital turnover ratio.
In order to better understand this metric, let’s take a step back: working capital is the money (current assets minus current liabilities) that a company can use to make product and operational improvements, after all the bills and debts have been paid.
Startups can better manage their working capital by maintaining a capital cushion to extend their runway and getting very efficient about managing their accounts receivable in order to keep business running as usual.
Having working capital is one thing, but measuring how you use it and having data to pivot your strategy, if needed, is another.
This is where the working capital turnover ratio (WCTR) comes into play. A simple mathematical formula (also known as net sales to working capital), it calculates how efficiently a company uses working capital to generate sales.
This ratio gives a company an accurate idea of how much money is available to put towards operations after all debt has been paid (information that is particularly useful for small businesses or early stage startups).
Companies with higher working capital turnover ratios are more efficient in running operations and generating sales (the more sales you bring in per dollar of working capital spent, the better).
Lower working capital turnover is an indicator that operations are not being run efficiently (your business may be investing in too many accounts receivable or inventory and fewer sales per working capital spent).
This metric is particularly useful to determine the financial health of a company at any given time and analyze if there needs to be any change in operational strategy in real time.
It can also be used to see if a company will be able to pay off its debts in a set period of time and avoid running out of cash flow as a result of increased burn requirements.
How do you calculate the working capital turnover ratio formula?
The working capital turnover ratio formula is calculated by dividing the company’s net annual sales by its average working capital (naturally, if your working capital turns negative then your working capital turnover ratio will also turn negative).
As a reminder: working capital is calculated by subtracting a company’s total liabilities & debts from its total assets. Information about your total liabilities and your total assets can typically be found on your balance sheet.
For example, if a company makes $10 million in sales during a calendar year and has $2 million in working capital reserves, then its working capital turnover ratio would be $5 million (calculated as: $10 million in net annual sales divided by $2 million in working capital).
Usually, working capital turnover ratios are calculated on a calendar year basis. However, companies can also calculate this ratio for a specific period of time as well since changes in liabilities or assets can affect a company's working capital turnover ratio. One thing to note is that the capital turnover formula does not take market considerations into account, so it will simply help you tell the story of what your numbers are saying but it will be up to you to determine why the numbers are performing the way they are.
We recommend tracking how your ratio changes over time (to determine what factors are most affecting your business) and to compare your ratio to that of other companies in the same industry. Doing so will show you how you compare against your competitors and will push you to optimize how you use your working capital for peak efficiency.
How can you use working capital turnover ratio to determine success for your business?
Because the working capital turnover ratio is such an illuminating metric that offers key insights into the financial health of your business, there are many benefits to your business when you stay aware of this metric.
Here are some of the most impactful reasons for staying aware of your working capital turnover ratio:
- Maintaining positive cash flow: When you don’t stay on top of your working capital turnover ratio, you may experience cash flow negativity for daily business operations and short-term debts. Incorporating working capital management into your business plan can help you stay aware of the status of your company's payable/receivable accounts, assets, and liabilities. This will make it so that you know how your cash is being spent, where to properly allocate it for maximum cash flow management and efficiency, and makes it so that you can avoid embarrassing and detrimental operational delays and interruptions due to cash flow imbalances.
- Improving overall financial status: Having a goal to stay within a specific working capital turnover ratio will mean that you use data from this metric to inform all your business decisions to optimize your cashflow usage so that each dollar you spend brings in the maximum value in sales closed. This efficiency should help to prevent you from running out of working capital and thus having to turn to outside sources, losing equity, or incurring debt.
- Enhancing profitability & value: A high working capital turnover ratio can enhance your company's overall value within your industry. This can help your business stand out among competitors, produce a higher return on capital spent, and receive better terms when you look to investors for expanding your business in the future.
- Alerting concern at the right time: While having a higher working capital turnover ratio is better than a lower one, there is a serious cause for concern if your ratio gets too high. An extremely high ratio (80%+) indicates your company does not have enough capital to support its sales growth and thus, is a cause for concern. This can lead to the company collapsing in the future if you don’t adjust your working-capital-to-sales ratio. If you experience this, you need to analyze your financial situation and quickly make appropriate adjustments to how you’re spending your cash flow to avoid insolvency.
How can you improve your working capital turnover ratio?
Increasingly, companies are looking to alternative financing as a more flexible way to access working capital, while maintaining ownership of their equity. The more working capital your company has, the higher chance you have of executing well on your sales plans and maintaining or improving your desirable working capital turnover ratio.
Growth financing (or as we like to call it at Capchase, programmatic financing) is a newer form of non-dilutive funding that allows SaaS companies and recurring revenue businesses to access capital on terms that feel similar to those offered through banks and more traditional lenders, but using anticipated growth of monthly recurring revenue (MRR) rather than assets or credit history. The other bonus is that the available capital is based on a percentage of your ARR and therefore will grow as you do, so you don’t need to continually renegotiate terms.
The working capital turnover ratio is a important metric to know and use in your financial planning. Not only is it simple to calculate, but it gives a very clear indication of how well your working capital is being used to increase your sales and grow your revenue.
Some factors to keep in mind:
- Working capital turnover measures how effective a business is at generating sales for every dollar of working capital spent.
- A higher working capital turnover ratio is better because it demonstrates that a business is generating higher sales per dollar spent.
- However, if working capital turnover rises too high (above 80%), it could suggest that your company needs to raise additional capital to support future growth to avoid insolvency. In this case, using a non-dilutive working capital solution might be the most efficient move.
Finding out how much efficient working capital you can access through Capchase using our runway calculator.