The Sales to Working Capital Ratio tells us how quickly a company can turn one dollar of capital into one dollar of sales.

ROIC, or Return On Invested Capital, on the other hand is a very useful way to measure how well a business is doing at making more money. The best businesses can grow without needing to spend too much money. A lesser-known ratio called the Sales to Working Capital Ratio can be used to figure out how well a company puts money back into itself. The Sales to Working Capital Ratio is an efficiency ratio that is also called the Working Capital Turnover Ratio or the Sales to Capital Ratio.

What is the Sales to Working Capital Ratio?

The Sales to Working Capital Ratio tells us how quickly a company can turn one dollar of capital into one dollar of sales.

To keep sales going, it usually takes a certain amount of money. For accounts payable to be paid off, there must be an investment in accounts receivable and inventory. So, even if a business's sales go up or down, there is usually a ratio of working capital to sales that stays pretty steady.

The sales-to-working-capital ratio can be used to measure this relationship, and it should be shown on a trend line so that spikes and dips are easier to spot. If the ratio goes up, it could be because the company decided to give customers more credit in order to get them to buy more. If it goes down, it could mean the opposite. A spike could also be caused by a decision to keep more stock on hand so that customer orders can be filled more easily. A trend line like this is a great way to show management how their decisions about working capital have turned out.

Let's quickly look at the Sales to Working Capital Ratio of some market leaders:

  • Apple – 3.56
  • Amazon – 4.13
  • Microsoft – 2.46
  • Tesla – 2.31
  • Google – 1.65

How to figure out the Sales to Working Capital Ratio

To figure out the Sales to Working Capital Ratio, divide the annualized net sales by the average amount of working capital. Here's how it works:

Annualized net sales ÷ Average Working Capital

  • A company's net annual sales are its gross sales minus returns, allowances, and discounts over a year.
  • Working capital is the difference between average current assets and average current liabilities.

How Sales to Working Capital Ratio affects Return on Invested Capital

ROIC is one way to figure out if a company has a "defensible economic moat," which is the ability to protect its profit margins and market share over time from new market entrants. The main goal of figuring out the metric is to get a better idea of how well a business has been using its operating capital (i.e. deployment of capital).The metric is often used by investors in the public markets to screen for possible investments. This is true not just for individual investors but also for institutional investors like hedge funds, especially those that use long-only, value-oriented strategies.

ROIC Formula

Return on Invested Capital (ROIC) = Net Operating Profit after Taxes (NOPAT) / Average Invested Capital

Invested Capital Formula

Invested Capital = Fixed Assets + Net Working Capital (NWC)

Components of ROIC

ROIC is made up of the following:

  • Revenue
  • Average Invested Capital
  • NOPAT (Net Operating Profit after Taxes)

By looking at the full formula for ROIC, we can see that value is the sum of:

  • Invested Capital Turnover: "How much money does each dollar of invested capital bring in?"
  • Margins: "How much of the profit is kept after taking out the cost of goods sold (COGS) and operating expenses (Opex) to get operating income (EBIT), which is then taxed?

The invested capital is affected by the net working capital. If operating assets go up, so does the invested capital, which makes the metric go down (i.e. more spending is needed to sustain or increase growth).

On the other hand, if operating liabilities went up, ROIC would go up because Net Working Capital is lower when operating liabilities go up.

A higher return on capital invested could mean that a company needs to spend less money to make more money.

If we look at the Sales to Working Capital Ratio and compare it to the ROIC of companies, we might find something interesting.

Sales to Working Capital Ratio Detail

The above charts show how important it is to be efficient. If we look at both charts, we can see that companies that use their free cash flow to grow their business value more effectively are those with a higher Sales to Working Capital Ratio. To put that into perspective, it costs Verizon one dollar to bring in an extra fifty-one cents. Apple makes an extra $2.99 per dollar of capital that is put back into the business. Please keep in mind that this is the view of an investor.

Analysts also compare a company's working capital ratio to those of other companies in the same industry and look at how the ratio has changed over time. This helps them figure out how well a company uses its working capital.

To conclude –

  • Sales to Working Capital Ratio evaluates the efficiency with which a company generates sales for each dollar of working capital employed.
  • A higher ratio shows that a business is able to generate a greater volume of sales (more efficient at utilizing Capital).
  • However, if it climbs excessively, it may indicate that a company needs to raise additional funds to sustain future expansion.

Hope you enjoyed this post on Sales to Working Capital Ratio, let me know what you think in the comment section below.

About the Author

 

Arun Panangatt, is a growth hacker and thought leader. He trys to help organizations and people find a purpose. He is father of an Autistic son and husband of a loving wife.

He talks about #innovation, #negotiations, #pricingoptimization, #realestatedevelopment, and #strategicpartnerships. He can be contacted on Linkedin, if you are excited to get in touch with him.