What it means
Two ingredients go into it. Net credit sales are sales made on account, after deducting returns, allowances and discounts, excluding anything paid for immediately in cash; working capital is current assets minus current liabilities, the short-term funding the business actually has to trade with.
The ratio matters because selling on credit consumes cash. Every invoice issued but unpaid is money the business has spent on stock, wages and overheads without yet being reimbursed, and working capital is what bridges that gap until customers pay.
A rising ratio can be read two ways and both readings deserve testing. It may mean the business has become more efficient, turning the same working capital over more times a year, or it may mean credit sales have outgrown the funding available to support them.
That second reading is overtrading, which is a genuine risk for fast-growing companies. Sales climb, the order book looks excellent, and the business runs out of cash because it is funding a rapidly expanding receivables book from a working capital base that has not grown with it.
The sensible way to use the ratio is as a trend against the company's own history and against peers in the same sector. A wholesaler on 60-day terms and a retailer selling for cash will produce completely different figures, so the level in isolation tells you very little.
In practice
Real-world examples.
Example
A packaging wholesaler tracks the ratio at around 5.5 times for three years, then sees it hit 8.2 times after landing two large contracts. Investigation shows receivables have grown 40% while working capital is flat, so the company arranges an invoice finance facility before the strain shows up as a missed supplier payment.
Example
An industrial parts supplier benchmarks itself against trade association figures and finds its ratio of 3.1 times is well below a sector norm nearer 5 times. The finance team concludes it is holding excessive stock and releases roughly $400,000 by cutting slow-moving lines.
Example
A commercial printer moves half its customers from 60-day to 30-day terms. Working capital rises as cash comes in faster, the ratio falls from 7.4 to 5.6 times, and the business gains headroom to take on larger jobs.
Think of it
“This ratio shows how hard your working capital works to support credit sales.
Formula
Calculation
Net credit sales to working capital ratio = net credit sales / average working capital
Where net credit sales = gross credit sales - returns, allowances and discounts, and working capital = current assets - current liabilities.
A building supplies distributor records gross credit sales of $6,300,000 for the year, with $300,000 of returns and allowances. Net credit sales = $6,300,000 - $300,000 = $6,000,000.
Its working capital was $800,000 at the start of the year and $1,200,000 at the end, so average working capital = ($800,000 + $1,200,000) / 2 = $1,000,000.
The ratio = $6,000,000 / $1,000,000 = 6.0 times. Every dollar of working capital supported six dollars of credit sales during the year.
If sales then grew to $9,000,000 while average working capital stayed at $1,000,000, the ratio would rise to 9.0 times. That jump is worth investigating, because the same funding base would be carrying half as much again in unpaid invoices.Case study
Seen in the real world.
What follows is a fictional and illustrative example. Stanmore Electrical Supplies, an invented distributor, grew credit sales from $4,000,000 to $7,200,000 in two years and its owners were delighted with the sales performance. Working capital stayed close to $900,000 throughout, so the ratio climbed from roughly 4.4 times to 8.0 times.
Nobody had been watching that number. The strain showed up instead as a series of late supplier payments, two lost early settlement discounts and an increasingly uncomfortable relationship with the company's largest wholesaler, all while the profit and loss account looked excellent.
Once the pattern was recognised in this illustrative case, Stanmore reduced its standard payment terms from 45 days to 30 for new customers, introduced a small early settlement discount and arranged a receivables finance line. Average working capital rose to about $1,400,000, the ratio settled near 5.1 times, and the supplier relationships recovered without any reduction in sales.
Watch out
Common mistakes.
- Using total sales rather than credit sales only, which inflates the ratio for any business with a meaningful proportion of cash takings.
- Taking working capital at a single year-end date, when a seasonal business can show a figure that bears no resemblance to its typical position.
- Reading a high ratio as pure efficiency without checking whether receivables and stock are growing faster than the funding supporting them.
Questions
People also ask.
What is a good level for this ratio?
There is no universal figure; compare it with the company's own history and with similar businesses on similar payment terms.
What happens if working capital is negative?
The ratio becomes meaningless, and analysts switch to measures such as the receivables collection period instead.
How often should it be reviewed?
Quarterly for most businesses, and monthly for any company growing quickly enough that its receivables book is expanding faster than its funding.
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