Learn how to calculate the working capital leverage of a company with the help of suitable examples.
One of the important objectives of working capital management is by maintaining the optimum levels of investment in current assets and by reducing the levels of current liabilities, the company can minimize the investments in working capital thereby improvement in return on capital employed is achieved.
The term working capital leverage, refers to the impact of level of working capital on company’s profitability. The working capital management should improve the productivity of investments in current assets and ultimately it will increase the return on capital employed.
Higher levels of investment in current assets than is actually required mean increase in the cost of interest charges on the short-term loans and working capital finance raised from banks etc. and will result in lower return on capital employed and vice versa. Working capital leverage measures the responsiveness of ROCE for changes in current assets.
The working capital leverage is measured by applying the following formula:
The working capital leverage reflects the sensitivity of the return on capital employed to the changes in level of current assets. Working capital leverage would be less in the case of capital intensive units, even though total capital employed is same. Working capital leverage expresses the relation of efficiency of working capital management with the profitability of the company.
Where, C.A. = Current Assets
T.A. =Total Assets (i.e., Net Fixed Assets + Current Assets)
ΔC.A. = Change in Current Assets
From the following information calculate the responsiveness of ROCE for changes in current assets:
Calculation of responsiveness of ROCE if the current assets decline by 20% over the existing level is calculated by applying the following formula:
Working Capital Leverage =
Company B =
From the above analysis it is observed that, working capital leverage is higher for Company B, and therefore, it is more responsive as compared to Company A.