Sales to working capital ratio is a liquidity and activity ratio that shows the amount of sales revenue generated by investing one dollar of working capital. Assets, also called working capital, represent items closely tied to sales, and each item will directly affect the results.
Therefore, this ratio measures how well the company is utilizing its working capital to generate revenue. Investors are able to understand how much cash is needed to support a given level of sales.
In day–to–day operations, there are short term debts and bills, such as salaries, that need to be met for the business to produce. Therefore investors typically track this ratio over time since it can provide insights into the company’s use of cash over some time and possibly need to raise additional funds to grow sales.
A high ratio indicates a company’s efficiency. How well are they utilizing current assets and liabilities to support growth in sales. A low sales to working capital ratio implies that the company’s working capital is not adequate enough to generate sales. Therefore, the company is excessively using accounts receivables and inventories to generate sales.
This might result in poor quality debts and obsolete inventory. In an ideal world, a company’s sales to working capital ratio should remain fairly constant regardless of its sales levels.
Sales to Working Capital Ratio Formula
$$Sales\: to\: Working\: Capital = \dfrac{Net\: Sales}{Average\: Working\: Capital}$$
The information for these variables can be found on a company’s financial statements. To calculate net sales, simply deduct sales returned from the annual gross sales.
$$Net\: Sales = Sales – Sales\: Returns$$
This is referred to as annualized net sales because we’ve deducted sales which were returned by customers to eliminate counting items in the inventory twice.
The average working capital is calculated as current assets minus current liabilities. You can find this by summing accounts receivable and inventories and deducting accounts payable.
$$Average\: Working\: Capital = Accounts\: Receivable + Inventory - Accounts\: Payable$$
Sales to Working Capital Ratio Example
After recording a series of poor sales performances, the credit department at Donald’s company decided to use another company in their industry as a benchmark. The team realized that their company could tighten its credit policy without significantly hurting sales.
As a result, they adjusted inventory levels by eliminating slow-moving products. After one year, the company achieved the results recorded in the table below. Use the information provided to find the change in the company’s sales to working capital ratio over the course of the year.
| Q1 | Q2 | Q3 | Q4 | |
| Gross Sales | $25,400 | $23,800 | $25,175 | $26,109 |
| Sales Returned | $400 | $300 | $500 | $200 |
| Accounts Receivable | $8,333 | $4,308 | $4,113 | $3,886 |
| Inventories | $12,500 | $9,400 | $8,636 | $7,773 |
| Accounts Payable | $1,042 | $783 | $720 | $648 |
Quarter 1
Now let’s break it down and identify the values of different variables in the problem. To calculate net sales subtract returns ($400) from gross sales ($25,400). For working capital, add the accounts receivable ($8,333) and inventory ($12,500), then subtract accounts payable ($1,042).
- Net sales= $25,000
- Working capital = $19,791
$$Sales\: to\: Working\: Capital = \dfrac{25{,}000}{19{,}791} = 1.26$$
The quarter 1 ratio is 1.26.
Quarter 2
Using the same method as quarter one, we can calculate net sales and working capital again for quarter 2.
- Net sales = $23,500
- Working Capital =$12,925
$$Sales\: to\: Working\: Capital = \dfrac{23{,}500}{12{,}925} = 1.82$$
The quarter 2 ratio is 1.82.
Quarter 3
- Net sales = $24,675
- Working Capital =$12,029
$$Sales\: to\: Working\: Capital = \dfrac{24{,}675}{12{,}029} = 2.05$$
The quarter 3 ratio is 2.05.
Quarter 4
- Net sales = $25,909
- Working Capital = $11,011
$$Sales\: to\: Working\: Capital = \dfrac{25{,}909}{11{,}011} = 2.35$$
The quarter 4 ratio is 2.35.
Overview
Over the four quarters, the sales to working capital ratio increased from 1.26 to 2.36. This means benchmarking helped the company to adapt its facilities to more profitable use of the working capital.
Sales to Working Capital Ratio Analysis
The sales to working capital ratio is an asset utilization measure. It allows investors to understand how well the company is using its assets to support a certain level of sales. Measured results over several periods because one-time ratios will only reveal how well the business is performing for that single period. Watching the trend helps you know if the company needs additional funds to grow their sales.
Usually, a certain amount of money must be invested in a company to support its operations. This amount should always be maintained at a certain level, regardless of the change in sales level. When the company is undercapitalized, they might tighten up customer credit or decrease on-hand inventory levels to reduce the amount of cash invested in receivables and inventory. However, this can result in reduced sales when the company’s payment terms become unattractive to clients. Or customers might turn to better-stocked competitors to fulfill their orders more quickly.
A high ratio indicates that the working capital is used more times per year, which means a more frequent flow of capital. Low ratios imply that the company’s working capital is not adequate for generating sales. This results in excessive use of accounts receivable and inventories to generate sales, a factor that might cause bad quality debts and obsolete inventory. The most attractive ratios are ones that remain constant over time, regardless of sales.
Sales to Working Capital Ratio Conclusion
- Sales to working capital ratio is a metric used to determine how efficiently the company is utilizing its current assets and liabilities to support a certain level of sales.
- A high result is an indicator of a company’s efficiency in utilizing current assets and liabilities to support growth in sales.
- A low sales to working capital ratio implies that the company’s working capital is not adequate to generate sales resulting in excessive use of accounts receivable and inventories to generate sales.
- The effectiveness of this ratio is best viewed over several periods.
- This formula requires two variables: net sales and average working capital.
Sales to Working Capital Ratio Calculator
You can use the sales to working capital ratio calculator below to quickly calculate the number of net sales a company can support by its current assets and liabilities by entering the required numbers.