Working capital productivity definition
/What is Working Capital Productivity?
The working capital productivity measurement compares sales to working capital. The intent is to measure whether a business has invested in a sufficient amount of working capital to support its sales. From a financing perspective, management wants to maintain low working capital levels in order to keep from having to raise more cash to operate the business.
Ideally, there is a midway point in this ratio that represents a reasonable usage of working capital to support the needs of a business. It is possible to drive for an excessively low proportion of working capital to sales, which can result in inventory stockouts and annoyed customers. To decide whether the working capital productivity ratio is reasonable, compare a company's results to those of competitors or benchmark businesses.
How to Improve Working Capital Productivity
You can improve your working capital productivity by implementing any of the following suggestions:
Grant less credit to customers, which reduces the amount of accounts receivable outstanding.
Implement a just-in-time production system in order to minimize inventory levels.
Negotiate with suppliers to lengthen your payment terms with them.
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Calculation of Working Capital Productivity
To derive working capital productivity, divide annual sales by the total amount of working capital. The formula is as follows:
Annual sales ÷ Total working capital = Working capital productivity
Example of Working Capital Productivity
For example, a lender is concerned that Hubble Corporation does not have sufficient financing to support its sales. The lender obtains Hubble's financial statements, which contain the following information:
| Annual revenues | $7,800,000 |
| Cash | $200,000 |
| Accounts receivable | $800,000 |
| Inventory | $2,000,000 |
| Accounts payable | $400,000 |
With this information, the lender derives the working capital productivity measurement as follows:
$7,800,000 Annual revenues ÷
($200,000 Cash + $800,000 Receivables + $2,000,000 Inventory - $400,000 Payables)
= 3:1 Working capital productivity
This ratio is lower than the industry average of 4:1, which indicates poor management of the company's receivables and inventory. The lender should investigate further to see if the receivable and inventory figures may contain large amounts of obsolete items.
Working Capital Productivity Best Practices
When using this measurement, consider including annualized quarterly sales in order to gain a better short-term understanding of the relationship between working capital and sales. Also, the measurement can be misleading if calculated during a seasonal spike in sales, since the formula will match high sales with a depleted inventory level to produce an unusually high ratio.