Description: It is exceedingly important to keep the amount of cash used by an organization at a minimum, so that its financing needs are reduced. One of the best ways to determine changes in the overall usage of cash over time is the ratio of sales to working capital. This ratio shows the amount of cash required to maintain a certain level of sales. It is most effective when tracked on a trend line, so that management can see if there is a long-term change in the amount of cash required by the business in order to generate the same amount of sales. For instance, if a company has elected to increase its sales to less creditworthy customers, it is likely that they will pay more slowly than regular customers, thereby increasing the company’s investment in accounts receivable. Similarly, if the management team decides to increase the speed of order fulfillment by increasing the amount of inventory for certain items, then the inventory investment will increase. In both cases, the ratio of working capital to sales will worsen due to specific management decisions. An alternative usage for this ratio is for budgeting purposes, since budgeted working capital levels can be compared to the historical amount of this ratio to see if the budgeted working capital level is sufficient.
Formula: Annualized net sales are compared to working capital, which is accounts receivable, plus inventory, minus accounts payable. One should not use annualized gross sales in the calculation, since this would include in the sales figure the amount of any sales that have already been returned, and are therefore already included in the inventory figure. The formula is as follows:
Annualized Net Sales
(Accounts Receivable + Inventory – Accounts Payable)
Cautions: Using this ratio to manage a business can result in unforeseen results, such as a drop in sales because of reduced inventory levels or tighter customer credit controls. Also, arbitrarily lengthening the terms of accounts payable in order to reduce the working capital investment will likely lead to strained supplier relations, which may eventually result in increased supplier prices or the use of different and less reliable suppliers.