What is working capital?
Working capital is to a business as wind is to a sailboat — sure, you might be able to drift along without it, laboriously paddling to avoid the rocks, but you really need it to make good progress. Working capital is the money (current assets minus current liabilities) that a business can spend to make essential payments, and manage and improve its operations, after all bills and debt installments have been paid.
A few common ways that startups can manage their working capital needs include:
Maintain a capital cushion: Keep funds in a bank account to help the business manage the normal ups and downs of cash flow cycles. These funds often come from an equity raise or long-term venture debt. As startups grow, working capital requirements tend to increase along with it, requiring a progressively larger capital cushion.
Factor accounts receivable: Sell receivables to banks or other financial service providers to off-set working capital requirements. This often costs an additional 1.5% to 2% per month (plus fees). Furthermore, factors require a business’s customers to send payments directly to the factoring company’s bank account, and the factoring company will usually contact the customer directly to verify each underlying sale.
Startup line of credit: Acquire a capital cushion to draw from with revolving working capital – a line of credit. With a line of credit, a business can draw funds to pay for regular business operations, as needed, and will only pay for the capital once it’s drawn – and only while it’s drawn. This non-dilutive financing solution is a flexible and revolving low-cost alternative to equity or venture debt.
Yet just having working capital at your disposal doesn’t guarantee that you’ll be making effective use of this essential resource. That’s a whole other matter, one that can be assessed by a metric called “working capital turnover,” also known as the working capital turnover ratio.
What is working capital turnover?
Working capital turnover is a ratio that quantifies the proportion of net sales to working capital, and it measures how efficiently a business turns its working capital into increased sales revenue. The working capital turnover ratio reveals the connection between money used to finance business operations and the revenues a business produces as a result.
How to Calculate Working Capital Turnover Ratio
Before you can calculate your working capital turnover ratio, you need to figure out your working capital, if you don’t know it already. To do so, take your current assets and subtract your total current liabilities. Both of these figures should be reported on your balance sheet.
Once you’ve got that number, divide your net sales for the year by your working capital for that same year. The resulting number is your working capital turnover ratio, an indication of how many times per year you deploy that amount of working capital in order to generate that year’s sales figures.
The working capital turnover ratio formula
Working Capital Turnover Ratio = Net Sales ÷ (Total Assets - Total Liabilities )
Working capital turnover ratio examples
Let’s look at a couple working capital turnover ratio examples to bring some context as to why this metric is so useful for measuring efficiency.
Say Company A had net sales of $750,000 last year and working capital of $75,000. Company A’s working capital turnover ratio is 10, which means the company spent that $75,000 ten times to generate its $750,000 in sales.
Company B, on the other hand had $750,000 in sales and $125,000 in working capital, resulting in a working capital turnover ratio of 6. Company B spent its working capital only six times throughout the year to generate the same level of sales as Company A.
How to assess your startup's ratio
As you may have guessed, a high ratio is better. The more sales you can bring in per dollar of working capital deployed, the better off you are. It’s generally considered a good thing to redeploy your working capital more times per year to gain your year’s net sales figures, as it means that money is flowing easily in and out of your business and is working to make you more money.
In our example, Company A’s working capital is doing exactly that — it’s working for the company. It’s working for the company ten times in a year, while Company B’s working capital is only working six times. Yet both companies have generated the same amount of sales. It looks like Company A’s money is being made to work harder than Company B’s money is.
As you can see from the comparison of Company A to Company B, it’s useless to look at your working capital turnover ratio in a vacuum. This metric is meant to help you compare the efficiency of your operations to your competitors or others in your sector, or to shed light on whether your operations are making progress year after year.
Why working capital turnover matters
The working capital turnover ratio is a useful metric to know. Not only is it simple to calculate, but it gives a very clear indication of how hard you’re putting your available capital to work to help your business succeed. Finding out how your number stacks up against competitors can push you to design more efficient uses for your working capital.
As an accountant character in one of my favorite (if little known) movies says, “Stop risking your money and start frisking your money!” I have a feeling that improving your working capital turnover ratio would be exactly what he means.
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Managing your company’s working capital and cash flow in an efficient and effective manner is crucial for success, especially in the world of startups.
Here at Lighter Capital, we offer SaaS startups non-dilutive revenue-based financing that adapts to the ebbs and flows of your business.
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