Working Capital Turnover Ratios
The BEC section of the CPA exam will test a candidate on the calculation and interpretation of working capital turnover ratios such us the inventory turnover ratio, accounts receivable turnover ratio, and accounts payable turnover ratio.
Turnover ratios are used to indicate the efficiency and/or effectiveness of a company’s management team. Turnover ratios use information from the annual income statement like sales and cost of goods sold and divide by the average asset amount over the course of the year. For turnover ratio’s, it is absolutely critical that you remember to take the average balance and not the ending balance from the balance sheet when calculating a turnover ratio.
Inventory turnover ratio – The inventory turnover ratio measures how many times a company sells through or flips their inventory during a time period such as a year. A company wants their inventory turnover ratio to be as high as possible as it indicates stronger sales and reduces the risk of obsolete or slow-moving inventory.
The inventory turnover ratio is calculated by dividing annual cost of goods sold by average inventory:
In the example below, to calculate inventory turnover, we would take cost of goods sold of $350,000 and divide by average inventory. To calculate average inventory, we take inventory of $50,000 in Year 2 and $52,000 in Year 3, which equals an average of $51,000. Divide cost of goods sold of $350,000 by average inventory of $51,000 and that equals an inventory turnover of 6.9 times in Year 3.
Accounts receivable turnover ratio – The accounts receivables turnover ratio will measure the number of times receivables are collected over an accounting period. The A/R turnover ratio typically is driven by the credit terms offered by a company to its customers and its ability to collect outstanding A/R from its customers.
The accounts receivable (A/R) turnover ratio is calculated by dividing annual sales (net) by average accounts receivable:
In the example below, to calculate A/R turnover, we would take sales of $550,000 and divide by average accounts receivable. To calculate average accounts receivable, we take A/R of $30,000 in Year 2 and $35,000 in Year 3, which equals an average of $32,500. Divide sales of $550,000 by average A/R of $32,500 and that equals an A/R turnover of 16.9 times in Year 3.
Accounts payable (A/P) turnover – This ratio measures how the rate at which a company pays outstanding invoices with its suppliers and credits. A higher A/P turnover ratio indicates that the company pays its invoices more quickly than if the A/P turnover ratio was lower.
The formula for the A/P turnover ratio is annual cost of goods sold divided by average accounts payable:
In the example below, to calculate A/P turnover, we would take cost of goods sold of $350,000 and divide by average accounts payable. To calculate average accounts payable, we take A/P of $20,000 in Year 2 and $24,000 in Year 3, which equals an average of $22,000. Divide cost of goods sold of $350,000 by average AP of $22,000 and that equals an AP turnover of 25.0 times in Year 3.
Working capital turnover – This ratio measures how efficiently a company is at utilizing its working capital to generate sales. A company with a higher working capital turnover ratio would be more efficient, while a company with a lower working capital turnover ratio would be less efficient (i.e., more inefficient)
In the example below, to calculate working capital turnover, we would take sales of $550,000 and divide by average net working capital. To calculate average net working capital, we take NWC of $66,000 in Year 2 and $73,000 in Year 3, which equals an average of $69,500. Divide sales of $550,000 by average working capital of $69,500 and that equals a working capital turnover of 7.9 times in Year 3.
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