Working Capital Turnover

It is important to understand working capital and the working capital ratio as it relates to a customer or applicant's credit standing and overall financial condition.  Working capital shows how much in current assets including cash that a company has to pay its debts and sustain its business. Working capital can be either positive or negative, depending on the relative size of current assets and current liabilities.

Another consideration of working capital involves working capital turnover.  This is the ratio of sales to working capital.  This turnover rate may indicate whether or not a company is overtrading.  A firm that is overtrading is potentially a serious credit risk. Often, such a company or customer buys in large amounts and pays its bills promptly. A company that is overtrading has limited reserve funds to serve as a cushion against hard times including weakening financial performance. An unexpected decline in the market for its products, or interrupted operations resulting from strikes, material shortages, or other causes, can ruin a company that is overtrading fairly quickly.  

Unfortunately for the credit department, there are often no warnings for creditors evaluating customers' financial condition or other indicators of financial stress such as slow trade payments that trigger credit department personnel to reduce or eliminate their credit limit before the customer fails.

Credit analysts use the rate of working capital turnover determined by the ratio of net sales to net working capital for much the same purpose.  Frequently, if a firm is in a low net worth position it will also have a low working capital position.  In this scenario, the turnover rates of both net worth and working capital will be high. This was the case with the Wood Company. Turning back to the Wood Company balance sheet you will notice that both of these turnover rates are well above the median figures for the line:

Net Worth Turnover

Net Sales ($1,000,000) / Tangible Net Worth ($170,000) = 5.88 (3.25 median)

Working Capital Turnover

Net Sales ($1,000,000) / Net Working Capital: ($125,000) = 8.00 (4.94 median)

In some cases, a company that is overtrading will have a normal net worth turnover.  Creditors often will not discover the increased credit risk until they check the rate of working capital turnover. Consider the scenario presented below:

Net Sales ($400,000) / Tangible Net Worth ($90,000) = 4.44

Howevwe, its rate of working capital turnover is well above the upper quartile (6.87):

Net Sales ($400,000) / Net Working Capital ($40,000) = 10.00

While having sufficient net worth, the company obviously has far too little working capital to carry on its operations adequately.

On scrutinizing the balance sheet you will see that the problem lies in the fixed asset figure. The company has over-invested in machinery and equipment. Notice that its ratio of fixed assets to net worth is a exceptionally high at 88.8 percent.  This 88.8% compares unfavorably when compared to a median figure of 37.8 percent.

Fixed Assets ($80,000) / Tangible Net Worth ($90,000) = 88.8%

Since such a large portion of its net worth is in fixed assets, the company must depend heavily on its creditors for working capital.  Therefore, this would be considered to be a marginal credit risk despite its apparently adequate net worth.

Funded Debts to Net Working Capital Ratio

The company's marginal creditworthiness is also indicated by another working capital ratio; the ratio of funded debt to net working capital.  By definition, funded debt is less pressing than current debt, but it is nonetheless an important factor in credit analysis. A customer who has little or no funded debt is a better risk than one who has already assumed substantial long-term obligations, since there is still the potential of obtaining funds by mortgaging property.

Although funded debt does not represent immediately maturing obligations, it can become burdensome in the long run. A prospective short-term creditor you should know how much of a burden a company's working capital must carry in paying the interest and principal on its funded debt. In the case of this company, this burden is heavy indeed.   The ratio of funded debt to working capital is nearly triple the median figure (31.1%):

Funded Debts ($30,000) / Net Working Capital ($40,000) = 75%

Profit Ratios

Profit ratios, most importantly the ratios of profit to sales and profit to net worth, are often looked upon as the best indicators of a company's relative efficiency within its field. Savvy financial analysts caution that these ratios are not always reliable indicators of a customer's creditworthiness.  An efficient company may lower prices and earnings in an effort to expand its markets.  While an inefficient company may temporarily enjoy high earnings by charging prices, they may eventually lose the sales and profits they presently enjoy.

In most cases, a company's profit ratios do reflect its efficiency and its credit strength. Usually, the ratios of profits to sales and net worth are used in conjunction with one another to evaluate creditworthiness. You would look for high or low earnings on sales (a high or low profit to sales ratio) to be confirmed by similar earnings on investment (a high or low profit to net worth ratio).  If these two ratios diverge, the cause of the divergence is likely to have considerable significance in the debtor company's financial strength and creditworthiness.

Suppose that Jones & Sons reports the following net worth, sales, and profit figures for the year just ended:

Net Worth: $40,000 Net Sales: $400,000 Net Profit: $4,000

The store's profit ratios are therefore:

Net Profit ($4,000) / Net Sales ($400,000) = 1% Profit to Sales Ratio

Net Profit ($4,000) / Net Worth ($40,000) = 10% Profit to Net Worth Ratio

While the store's profit to sales ratio is below the lower quartile for the industry (1.49%), its profit to net worth ratio is above the median (8.82%).  This combination of low profit to sales and high profit to net worth usually reflects one of three conditions. Either the store is doing good business at cut-rate prices, or it is a not very efficient shoestring operation, or it is an inefficient business which somehow derives income from other sources. A creditor would have to gather more data to decide which description applies to Jones & Sons.

Another retailer might report the following data in its year-end statements:

Net Worth: $180,000 Net Sales: $240,000 Net Profit: $8,000

Net Profit ($8,000) / Net Sales ($240,000) = 3.33% Profit to Sales Ratio

Net Profit ($8,000) / Net Worth ($180,000) = 4.44% Profit to Net Worth Ratio

In this case, the profit to sales ratio is considerably higher than the median figure (2.67%) but the profit to net worth ratio is well below the median figure (6.55%). This combination of high profits to sales and low profits to net worth indicates an efficiently run business with conservative financing.  

Edited by Michael C. Dennis.  Mr. Dennis is a consultant and the author of "The Credit and Collection Forms and Procedures Manual."