Working Capital to Sales Ratio - Meaning, Formula, Assumptions and Interpretation

Formula

Working Capital to Sales Ratio = Working Capital / Sales

Meaning

Stating the working capital as an absolute figure makes little sense. Consider two companies, both having the same working capital of USD 100. While one company uses this working capital to generate sales of USD 500, the other uses the same amount as working capital to generate USD 1000 in sales. Which one do you think will be more profitable? Which one do you think is more efficient?

When companies use the same working capital to generate more sales, it means that they are using the same funds over and over again. This is why this ratio is also called “Working Capital Turnover Ratio” as it measures the number of times working capital has been turned over. The higher the sales, the more the profits and therefore the more appropriate use of working capital has been made.

Assumptions

The working capital to sales ratio uses the working capital and sales figures from the previous year’s financial statements. Hence, there is obviously an assumption that working capital and sales have been accurately stated. Companies may over stock or under stock because of expectations of shortage of raw materials. These influences are however short term. Thus while reading this number the analyst must compare it with the past numbers to see if this is usual state of affairs for the company or whether this is an exception.

Interpretation

  • Efficiency Vs Riskiness: While many investors feel that a company must use as little working capital as possible, there are many that have other opinions too. These are conservative investors that fear having too little working capital can be dangerous as it is capable of causing a cash crunch and bringing the operations to a halt. These investors believe that in a cash crunch situation, the company may have to borrow at unfavorable terms nullifying the advantage gained by maintaining lower working capital and causing loss in the form of lost reputation.

    These investors may be true because the stock market takes any news of cash shortage very seriously and the stock plummets in the market. But the price in the stock may be short term.

  • Room For Improvement: Working capital to sales ratio may be a hint to the company that it needs to rethink its policies. If the competitors can get a better deal from suppliers and buyers then the company needs to build more bargaining power in the market. This is a signal that improvements need to be done.


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