Sales to working capital ratio
/What is the Sales to Working Capital Ratio?
It usually takes a certain amount of invested cash to maintain sales. There must be an investment in accounts receivable and inventory, against which accounts payable are offset. Thus, there is typically a ratio of working capital to sales that remains relatively constant in a business, even as sales levels change.
This relationship can be measured with the sales to working capital ratio, which should be reported on a trend line to more easily spot spikes or dips. A spike in the ratio could be caused by a decision to grant more credit to customers in order to encourage more sales, while a dip could signal the reverse. A spike might also be triggered by a decision to keep more inventory on hand in order to more easily fulfill customer orders. Such a trend line is an excellent feedback mechanism for showing management the results of its decisions related to working capital.
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How to Calculate the Sales to Working Capital Ratio
The sales to working capital ratio is calculated by dividing annualized net sales by average working capital. The formula is:
Annualized net sales ÷ (Accounts receivable + Inventory - Accounts payable) = Sales to working capital ratio
Management should be cognizant of the problems that can arise if it attempts to alter the outcome of this ratio. For example, tightening credit reduces sales, shrinking inventory may also reduce sales, and lengthening payment terms to suppliers can lead to strained relations with them.
Example of the Sales to Working Capital Ratio
A credit analyst is reviewing the sales to working capital ratio of Milford Sound, which has applied for credit. Milford has been adjusting its inventory levels over the past few quarters, with the intent of doubling inventory turnover from its current level. The result is shown in the following table:
| Quarter 1 | Quarter 2 | Quarter 3 | Quarter 4 | |
| Revenue | $640,000 | $620,000 | $580,000 | $460,000 |
| Accounts Receivable | 214,000 | 206,000 | 194,000 | 186,000 |
| Inventory | 1,280,000 | 640,000 | 640,000 | 640,000 |
| Accounts Payable | 106,000 | 104,000 | 96,000 | 94,000 |
| Total Working Capital | 1,388,000 | 742,000 | 738,000 | 732,000 |
| Sales to Working Capital Ratio | 1.8:1 | 3.3:1 | 3.1:1 | 3.1:1 |
The table includes a quarterly ratio calculation that is based on annualized sales. The table reveals that Milford achieved its goal of reducing inventory, but at the cost of a significant sales reduction, probably caused by customers turning to competitors who offered a larger selection of inventory.
How to Improve the Sales to Working Capital Ratio
It can be quite difficult to improve a company’s sales to working capital ratio. This difficulty stems from the nature of the measurement. If you try to reduce working capital by cutting back on customer credit, then customers may take their business elsewhere, resulting in a sales decline. Or, if you try to reduce inventory levels, the time required to ship orders to customers will likely slip, which can also result in reduced sales. Consequently, paring back the working capital part of the equation will rarely result in a performance improvement in the ratio. A better option is to invest more heavily in product enhancements, so that customers will be more interested in buying the product even if you cut back on customer credit or inventory levels. In short, having a “hot” product gives you the leeway to cut back on working capital, thereby enhancing the ratio.