Return on working capital definition
/What is the Return on Working Capital?
The return on working capital ratio measures how efficiently a company utilizes its working capital to generate earnings. A higher rate of return indicates that the company is effectively using its short-term assets and liabilities to produce profits, while a lower ratio may suggest inefficiencies in managing inventory, accounts receivable, or short-term debt. This ratio is particularly useful for assessing the liquidity and profitability of businesses that rely heavily on short-term assets, such as retailers and manufacturers. However, companies with negative working capital (e.g., businesses that collect cash upfront while delaying payments to suppliers) may still have strong financial health, so the ratio should be analyzed in the context of the company's industry and operating model.
How to Calculate the Return on Working Capital
To calculate the return on working capital, divide earnings before interest and taxes for the measurement period by working capital. The formula is:
Profit/loss before interest and taxes ÷ (Current assets - Current liabilities)
= Return on working capital
If the ending working capital figure for the period is unusually high or low, consider using an average figure for the reporting period instead.
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Disadvantages of the Return on Working Capital
This ratio should only be considered a general indicator of working capital performance, for it does not take into consideration a number of additional factors. They are as follows:
Profit drivers are intangible assets. A business might be able to generate unusually large profits because of key patents, which have nothing to do with the working capital investment.
Profit drivers are fixed assets. The key driver of profits may be the fixed asset base, such as the equipment used by an oil refinery. This large investment is not included in working capital.
Necessary business requirements. In order to do business in certain industries, it may be necessary to offer customers lengthy payment terms and high order fulfillment rates, which require a large investment in working capital.
Despite the objections just noted, it can be useful to track this ratio on a trend line, to see if the return is worsening. If so, an event may have occurred since the last measurement period which can be corrected.