Working Capital Formula & Turnover Ratio: Analyzing Financial Health

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25 JANUARY, 2024

To determine the financial health of a company, finance teams need to have a handle on two metrics: cash flow and working capital. A business with positive working capital is likely to have a greater chance of withstanding financial challenges and the flexibility to invest in future growth after meeting short-term obligations.

Knowing the amount of working capital your company has on hand is one of the most efficient ways of determining whether you need to cut costs to expand your business ventures. This article explains working capital, working capital turnover ratio and the formula for calculating it in detail. Let's dive right in!

Working Capital Formula

Net Working Capital (NWC), also known as working capital, is the difference between a company's current liabilities, such as debts and accounts payable and its present assets, such as customers' unpaid bills/accounts receivables, cash and inventories of finished goods and raw materials. NWC is commonly used to assess an organisation's short-term financial health and liquidity.

If the ratio of current liabilities to assets of a company is less than one, i.e., if a company has less current assets than current liabilities, then the company has negative working capital. It indicates low liquidity, poor short-term health and potential problems in paying off its due debt obligations. The company might even go bankrupt.

And if the company has more current assets than liabilities, then the company has a positive working capital. It means that a company has the funds necessary to fund its current operations as well as invest in future activities and growth.

You can find the working capital by subtracting a company's current liabilities from its assets. In the case of public companies, you can obtain these figures from their publicly disclosed financial statements.

The working capital formula is as follows:

Working Capital formula = Current Assets - Current Liabilities

How to Calculate Working Capital with the Help of Formula?

After paying off short-term liabilities, the working capital requirement formula tells you about the short-term liquid assets at hand. It is necessary for financial modelling, managing cash flow and performing financial analysis. You can calculate the working capital by the above-mentioned formula.Here is an example to help you understand:

Current Assets	Amount
Cash	₹ 30,000
Accounts receivable	₹12,000
Inventories	₹28,000
Total (T1)	₹70,000
Current Liabilities	Amount
Accounts Payable	15,000
Short-term borrowings	₹2,000
Accrued liabilities	₹5,000
Total (T2)	22,000
Working Capital (T1-T2)	₹48,000

Adjustments to the Working Capital Formula

The formula and example of working capital mentioned above is the most standard definition of working capital. Nevertheless, there are other more focused definitions of working capital.

Examples of alternative formulas:

⦁ Current Assets - Cash - Current Liabilities (excluding cash)
⦁ Accounts Receivable Inventory - Accounts Payable ( this includes solely the "core" accounts that constitute the working capital in the day-to-day operations of a business.)

What is a Good Working Capital Ratio?

A ratio between 1.5 to 2 is considered a good working capital ratio and suggests that the company is on solid ground. It indicates that the company has enough money on hand to pay its suppliers, employees or lease without difficulty.

However, a higher working capital ratio doesn't mean that it is good working capital. A working capital ratio above 3 might suggest that a company is not utilising its assets efficiently to generate future worth. A company's assets should work as hard as its employees. For instance, looking for new markets, developing new services and products, and planning to remain competitive.

What is the Working Capital Turnover Ratio?

The working capital turnover ratio helps in identifying the company's efficiency in utilising its working capital to generate sales. The ratio is determined by dividing net annual sales by its average working capital. A higher turnover ratio means the company generates more revenue for every unit of working capital. A high turnover ratio also means the company is more efficient in generating sales and running operations.

To improve a low turnover ratio, a company must consider managing its inventory levels and credit/debtor management to increase revenue and gain insights for sales strategies and future purchasing. Enhancing this ratio might lead to better resource utilisation and financial performance.

A working capital turnover ratio lower than 1 might indicate potential future liquidity problems. If a company's turnover ratio is 0.5, then it needs to evaluate its operations and devise more cost-effective operational solutions. A turnover ratio of 1.5 to 2 predicts good financial health for a company.

What is the Working Capital Turnover Ratio Formula?

After determining the working capital by subtracting a company's current liabilities from its current assets, you can calculate the working capital turnover ratio using the following formula.

Working Capital turnover ratio = Net annual sales/ Working Capital.

Let us take an example to understand in detail how to calculate any company's working capital turnover ratio.

Revenue(Sales)	₹ 16 million
Current Assets	₹ 10 million
Current Liabilities	₹ 2 million
Working Capital	₹ 8 million

To determine the turnover ratio, you need to divide sales by average working capital.

₹ 16 million / ₹ 8 million, which equates to 2.

Conclusion

The working capital formula determines the short-term financial health of a company. It reflects how well the company can pay off its debts and fund its current operations without relying on external funding. A negative working capital ratio should be a warning sign that a company might have difficulty keeping its head above water. Thus, maintaining an optimal working capital and working capital turnover ratio is crucial for a company.

FAQS

Q1. How do you Calculate Working Capital?
Working capital is the difference between a company's current assets and liabilities. You can calculate working capital by deducting a company's current liabilities from its current assets.

Q2. What is a Good Working Capital Ratio?
A working capital ratio between 1.5 to 2 is generally considered a good working capital ratio. This ratio indicates that a company is on solid financial grounds in terms of its liquidity.

Q3. What is the Net Working Capital Ratio?
A net working capital ratio, popularly known as working capital ratio, is the difference between a company's current liabilities, such as debts and accounts payable and its current assets, which include cash, customer's unpaid bills/accounts receivables and inventories of finished goods and raw materials.

Q4. What is the Formula of Working Capital in India?
The formula for calculating working capital is the same everywhere. Thus, in India, you can calculate your company's working capital by deducting your company's current liabilities from its current assets.

Working Capital Formula = Current Assets - Current Liabilities

Q5. How do you Calculate the Working Capital Turnover Ratio?
You can calculate the working capital turnover ratio by dividing your company's net annual sales by its working capital. This ratio indicates how well your company generates sales using its working capital.