Capital Turnover

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. read more) 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 read more 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 revenue, 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

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Source: Capital Turnover (wallstreetmojo.com)

Capital Turnover = Total Sales / Shareholder’s Equity

Where,

Example

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. read more and commission income was $8,000 in totality. Now we need to calculate capital turnover for FY 2014-15.

Solution

Total sales do not include other income like interest and commission income.

Calculation will be –

Capital Turnover Example

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

Interpretation

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:

Capital Turnover Criterion

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Source: Capital Turnover (wallstreetmojo.com)

#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.read more 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.

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. read more 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.

Advantages

Disadvantages

  • 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 assets, 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.

Conclusion

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.

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