What is the Working Capital Productivity Ratio?
The Working Capital Productivity Ratio helps explain how well the company is using its working capital. Historically this has been a useful guide to investors or stakeholders seeking to assess a company’s ability to manage cash. Any measure of cash management is important to understand since a business needs cash to operate, this is the oxygen that businesses need to live. This ratio is purported to have been established by the US management consultant George Stalk while working in Japan. The ratio gives a possible indication of the relationship between financial performance and process improvement.
A Definition of the Working Capital Productivity Ratio
The Working Capital Productivity ratio can be defined as:
Working Capital Productivity Ratio = Revenue / (Current Assets – Current Liabilities)
This therefore differs to the current ratio because it compares the income element of revenue (often called sales) to the net current assets.
What Other Working Capital Productivity Calculations Exist?
An alternative calculation used by some investors is in fact the same calculation, but simply uses different terminology. This alternative working capital productivity definition is:
Working Capital Productivity Ratio = Sales / Net Current Assets
This can also be defined as:
Working Capital Productivity Ratio = Sales / Working Capital
What does the Working Capital Productivity Ratio Mean to Industry and the Investor?
As discussed above this ratio assesses the organization’s ability to generate sales from its net assets. A high ratio can be indicative of a company which is successful at converting its net current assets into sales. The Working Capital Productivity ratio also gives the investor indicators of the organization’s ability to use money effectively.
Why does industry view the Working Capital Productivity Ratio as Important?
Investors and stakeholders may find it useful to compare the Working Capital Productivity ratio of a company compared to the Working Capital Productivity ratio of similar companies and the industry. This can help give an indication of how well the organization is perceived from a risk perspective. The Working Capital Productivity ratio is only one of many ratios and is used to raise more questions, however it remains an important cash related financial ratio. Historical Working Capital Productivity ratio analysis can also provide useful insights, because this historical analysis when assessed against the industry analysis can provide insights into the historical risk level of the business.
Is a Historically High Working Capital Productivity Ratio Good or Bad for the Investor?
Simplistically the higher the ratio the higher the perceived ability of the company to utilise its net current assets in generating sales. On the face of it this would imply less risk, however it is important to carry out further assessment to address the key problems analyzed below.
What are the Key Challenges with Working Capital Productivity Ratio Analysis?
Three possible problems with the Working Capital Productivity ratio are:
- Investors & industry may incorrectly make the assumption that a high ratio makes the best investment. As with all ratios a single ratio should not be used to make investment decisions. A trend by month or quarter may be one alternative approach.
- Investors & industry may compare ratios with inappropriate companies, however such comparisons may also give management evidence that processes need to be improved or re-engineered.
- Investors & industry should not look at the ratio in isolation. More insight can be gained by comparing with other organizations or industry. It is however critical to understand any variance in accounting policies when carrying out such an analysis.
What are the other issues with Working Capital Productivity Ratio Analysis?
Some other challenges with the Working Capital Productivity ratio include the following:
- Working Capital Productivity ratios are calculated using historical data. Historic data is not always the most appropriate basis for assessing future returns
- The Working Capital Productivity can vary due to short-term influences
What is the Working Capital to Sales Ratio?
This ratio uses the same data points of Sales and Working Capital but with the ratio defined as:
Working Capital to Sales Ratio = (Working Capital / Sales) x 100%
Again this may be defined in alternative ways, such as:
Working Capital to Sales Ratio = (Net Working Capital / Sales) x 100%
or
Working Capital to Sales Ratio = ((Current Assets – Current Liabilities) / Sales) x 100%