What is Capital Turnover?
Capital turnover is the measure that indicates organization’s efficiency in relation to the utilization of capital employed in the business and it is calculated as a ratio of total annual turnover divided by the total amount of stockholder’s equity (also known as net worth) and the higher the ratio, the better is the utilization of capital employed.
The capital turnover (also called equity turnoverEquity TurnoverThe equity turnover ratio depicts the organization's efficiency to utilized the shareholders' equity to generate revenue. It is evaluated by dividing the total sales from the average shareholders' equity. ) is a measure that calculates how efficiently the company is managing the capital investedCapital InvestedInvested Capital is the total money that a firm raises by issuing debt to bond holders and securities to equity shareholders. Invested Capital Formula = Total Debt (Including Capital lease) + Total Equity & Equivalent Equity Investments + Non-Operating Cash by the shareholders in the company to generate revenues. If the ratio is high, it shows that the company is efficiently utilizing the amount of capital invested. In contrast, if the ratio is low, then it indicates that the company is not managing its capital investment efficiently to generate the required revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions., i.e., the company has to invest the funds appropriately to achieve the sales target by utilizing the owner’s funds in the company.
Capital Turnover Formula
Capital Turnover = Total Sales / Shareholder’s Equity
- The total sale of the company is the total turnover of the company in an accounting year or of a period for which the ratio is calculated.
- The shareholder’s equity EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period., also known as capital employedCapital EmployedCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."/net worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus., is the total amount of investment made by shareholders in the company till the date of calculation of the ratio.
There is a company named ABC incorporation that started a business of manufacturing and supplying car batteries in the year 2013. For raising funds, the company issued equity shares and preference shares. The total of equity shares paid and issued amounted to $25,000, and the preference shares were $15,000 till the end of March 2015, i.e., other liabilities of the business were 40,000 in total till the end of the financial year 2015. The turnover of the business in the financial year 2014-15 was $500,000, and interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. and commission income was $8,000 in totality. Now we need to calculate capital turnover for FY 2014-15.
Total sales do not include other income like interest and commission income.
Calculation will be –
Total Shareholder’s Equity = Equity Shares + Preference Shares (Does not include liabilities)
- Total shareholder’s Equity = 25000 + 15000 = 40000
- Capital Turnover Ratio = 500000 / 40000 = 12.5
It means each $ of capital investment has contributed $12.5 towards the sales of the company, and this 12.5 seems that the utilization of capital investment is done efficiently by the company.
Capital Turnover Criterion
Capital Turnover Criterion implies the basis for the application of capital to get the maximum benefits and returns. The criterion is based on the following factors:
#1 – Market Reputation and Management of Resources
As it is total sales divided by net worth, so net worth is shareholders’ fund, which can be gained through market advantage like a higher reputation in the market and effective management of resources like management of employees, stakeholders, governmental compliance, etc. to ensure good market reputation.
#2 – Future Benefits and Payback Period
Before the application of capital, the future benefits from the investment and payback periodPayback PeriodThe payback period refers to the time that a project or investment takes to compensate for its total initial cost. In other words, it is the duration an investment or project requires to attain the break-even point. are to be analyzed to maximize the returns and to ensure optimum utilization of resources. The higher the payback period, the higher will be the capital turnover ratio.
#3 – Market Conditions
If the market conditions are favorable, then investment will yield a good result. If there are adverse market situations like inflation, scarcity of resources, etc., the investment will not yield good results due to adverse market conditions. Favorable market conditions increase the turnover of the organization.
#4 – Debt-Equity Mix and Legal Compliance
If the debt is more than the equity, then the net worth becomes low, and the ratio becomes adverse as it only considers the shareholders’ fund or owned fund. The higher debt-equity ratioDebt-equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. indicates that sale is more financed by borrowings. Also, proper legal compliance increases the market reputation, and investors’ attraction towards investment increases, which results in a higher capital turnover ratio.
- Optimum utilization of resources is possible as the capital is applied to earn the maximum revenue.
- Ensures sufficient liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. in the hands of the organization;
- Ensures Increase in manpower efficiency due to better management.
- High turnover ensures the smooth running of the business and attracts more investors.
- High equity turnover helps in expansion and diversification.
- A high turnover gives an advantage over the competitors as due to better manage the benefit can be passed to customers, which attracts more customers.
- It also prevents sudden liquidity crunches and ensures the good financial health of the organization.
- This ratio is more significant than normal, i.e., if more than 70%, then it indicates that the organization is more reliant on monetary factors, which gives higher profit and sales. Still, with monetary factors, non-monetary factors are to be balanced, for example, satisfied stakeholders.
- Greater the capital turnover ratio greater the investment in short term assetsShort Term AssetsShort term assets (also known as current assets) are the assets that are highly liquid in nature and can be easily sold to realize money from the market. They have a maturity of fewer than 12 months and are highly tradable and marketable in nature., which creates doubt about going concern assumption.
- It ignores the profit it is only concerned with sales. So, there is a possibility that the profit is reduced even though sales are increased.
Capital Turnover is calculated as total sales divided by total shareholders’ equity, which shows how efficiently the organization has utilized the capital invested by the investors. It reflects the efficiency of the management as well as the organization. The calculation of ratio shows how much per $ of investment contributed to the turnover of the organization. The basic criterion for this turnover is market advantage and management of resources. Stable capital turnover indicates the sufficient liquidity and achievements of timely targets to maximize the shareholders’ wealth. But the major drawback of equity turnover is it only focuses on sales, and profit maximization object is ignored.
This article has been a guide to what is Capital Turnover? Here we discuss how to calculate capital turnover and its formula along with a practical example and criterion. You can learn more about accounting from the following articles –