A companies capital turnover, (usually referred to as the Working Capital Turnover Ratio), is a measure of how well the company is generating sales from its working capital.

A look at how it's calculated, may clarify the importance of this ratio, and its value to investors. The formula for this ratio is:

Working Capital Turnover Ratio = Sales / Working Capital

where Working Capital = current assets - current liabilities

The thinking behind this ratio is that a company uses its working capital to fund operations, and to buy inventory. The operations and inventory then generate sales revenue for the company. The ratio measures the relationship between the capital used and the sales generated. Essentially, the higher the ratio the better because it means the company is generating more sales for dollar spent.

Let's look at a simple example. Joe's Wagon Works has $100 which it used to buy parts, and assemble wagons. It builds up an inventory of 10 assembled wagons. These wagons are then sold and shipped to its dealers, for $20 each (the dealers in turn sell them for $30, no wonder wagons are so expensive!). Joe's makes a profit, and is able to repeat the process 4 more times during the accounting period in question. So, sales for the period are $800 (10 wagons x $20 x 4 cycles). Joe's Working Capital Turnover Ratio = $800 / $100, or 8.0.

A competitor, Ed's Wagons, uses the same $100 to produce 8 wagons, which are sold for the same $20, and achieves the same 4 cycles. So, sales for the period are $640 (8 wagons x $20 x 4 cycles). Ed's Working Capital Turnover Ration = $640 / $100, or 6.4.

Joe's ratio is 8.0; Ed's is 6.4. Which company would you invest in?

It can be seen, therefore, that in an important sense, the working capital turnover ratio is a measure of management effectiveness in running the business. Comparisons can be made to other companies in the same business sector, or to a companies own historical record to see how its doing.

The process of calculating a companies working capital turnover ratio is more complex then the basic formula given above. First, extracting the necessary information from a balance sheet can be challenging, in part because companies can choose different accounting approaches, so digging out the right info isn't easy. The gory details are beyond the scope of this article, but suffice it to say the investor is better off finding a source for this information unless he or she has a lot of time to devote to it.

Happy investing.

Learn more about this author, Vic Moro.
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