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The working capital and turnover measurements are used by operations managers to track the efficiency of the operations.
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Working Capital Measurements
The working capital and turnover measurements indicate business operations efficiency.
When to Use Working Capital Measurements
These measures are normally used by operations managers to track the efficiency of the operations. Most organizations that use these measures update them either weekly or monthly.
- Many operational measures and accounts are turned into “turnover” ratios. This means the account is divided into the most recent 12 months of sales. The ratio shows how many times the account “turns over” during the course of the year. The higher the ratio the better, since it shows that the business is taking its assets and turning them into sales.
- Working capital is a measure of how well the operations management team is running the business.
- Working capital is the difference between current assets and current liabilities. The primary components of current assets are cash and equivalents, accounts receivable and inventory. The primary components of current liabilities are accounts payable and short term debt.
- A working capital value that is negative indicates the business may not be able to pay its bills.
- Working capital is sometime shown as the working capital ratio which is the current assets divided by the current liabilities. This allows investors and managers to compare business units with very different magnitude of operations for efficiency. Generally a value greater than 1.5 is good. However, a value that is too high could indicate that excessive inventory or receivables were accumulating. A working capital ratio that is less than 1 indicates the business may not be able to pay its bills.
- Working capital is often turned into a ratio known as working capital turnover by dividing it into the most recent 12 months of sales. This ratio makes no sense if the working capital nears zero or goes negative. The higher the working turnover, the better the business efficiency. Working capital turnover ratios can be increased by increasing sales without increasing working capital or decreasing inventory and receivables without reducing sales.
- There are two variations on the working capital turnover ratio that do a turnover ratio with only one of the working capital elements. These two ratios are inventory turnover and receivables turnover.
- Inventory turnover takes the most recent 12 months of sales and divides it by the value of the inventory on hand. The higher the ratio, the better the company has been able to turn inventory into sales.
- A variation on this ratio uses the past 12 months of Cost of Goods Sold (COGS) instead of sales. This removes the effect of pricing and ensures that the ratio is just “inventory sold” over “inventory on hand.”
- Receivables turnover takes the most recent 12 months of sales and divides it by the value of Accounts Receivable. The higher the ratio the better the company has been able to convert sales into cash.
- Both inventory turnover and receivables turnover are sometime expressed in units of “days.” This is done by dividing the turnover value into 365 days. This represents how many days are required for the inventory to be sold and replaced or for the receivables to be collected. With these measures, the smaller the number the better.
Hints and Tips
- Working capital is tricky. Both too high and too low are problems. Most manufacturing companies set a target that is a working capital ratio between 1.5 and 2.5. However, your business may be working to a different target depending upon its strategy.
- When turnover is expressed as a ratio, the higher the value the better. When turnover is expressed in days, the lower the value the better.
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