Sales to Working Capital

Definition

The term sales to working capital ratio refers to a calculation that allows an investor-analyst to understand if a company is facing a liquidity problem. Since the metric can vary by industry, this ratio is best used as a benchmark and / or tracked over time.

Calculation

Sales to Working Capital = Annualized Sales Revenue / Working Capital

Where:

• While current assets include balance sheet items such as cash, marketable securities, prepaid expenses, accounts receivable, and inventory; working capital removes accounts payable from metric.

Explanation

Liquidity measures allow the investor-analyst to understand the company's long term viability in terms of fiscal health. This is usually assessed by examining balance sheet items such as accounts receivable, use of inventory, accounts payable, and short-term liabilities. One of the ways to understand the overall liquidity position of a company is by calculating their sales to working capital ratio.

Also referred to as working capital productivity, sales to working capital subtracts accounts payable from current assets and provides a better indicator of liquidity than metrics such as sales to current assets. Since inventory on hand and sales using credit cards will vary by industry, this metric is best used as a benchmark or tracked over time to look for an unwanted pattern. For example, a ratio that increases over time may indicate a decline in inventory, which not only makes it hard to deliver product but also may indicate trouble raising cash to pay for purchases.

Example

The manager of a large mutual fund would like to assess the liquidity position of Company ABC. He believes the sales to working capital ratio would provide a good understanding of the company's position relative to its competitors. He asked his analytical team to calculate this metric over time for Company ABC in addition to benchmarking the ratio against several of the company's direct competitors.

The analytical team identified the benchmark value as 7.2, while the table below contains Company ABC's information over the last three years.

 Year 1 Year 2 Year 3 Sales \$107,740,800 \$123,840,000 \$148,608,000 Current Assets \$26,935,200 \$21,351,724 \$22,180,299 Current Liabilities \$9,250,000 \$5,474,801 \$5,098,920 Working Capital \$17,685,200 \$15,876,923 \$17,081,379 Sales to Working Capital 6.1 7.8 8.7

While Company ABC's ratio was initially better than benchmark, the data indicated a sharp increase over the last three years. Based on this analysis, the manager asked his analytical team to take a closer look some additional liquidity metrics.