Capital Turnover

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What is Capital Turnover?

Capital turnover is the measure that indicates an organization’s efficiency about 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.

Capital turnover (also called equity turnover) is a measure that calculates how efficiently the company is managing the capital invested by the shareholders in the company to generate revenues. If the ratio is high, it shows that the company efficiently utilizes the amount of capital invested. In contrast, if the ratio is low, 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 company.

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Capital Turnover Formula

capital turnover

Capital Turnover = Total Sales / Shareholder’s Equity

Where,

  • The company's total sale 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, also known as equity capital employed/ net worth,  is the total amount of investment made by shareholders in the company till the date of calculation of the ratio.

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 business liabilities were 40,000 in total till the end of the financial year 2015. The business's turnover in the financial year 2014-15 was $500,000, and interest income and commission income was $8,000 in totality. So 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 company's sales, 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

#1 - Market Reputation and Management of Resources

As it is total sales divided by net worth, 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 employees, stakeholders, governmental compliance, etc., to ensure good market reputation.

#2 - Future Benefits and Payback Period

Before applying capital, the future benefits from the investment and payback period are to be analyzed to maximize the returns and ensure optimum utilization of resources. The higher the payback period, the higher the capital turnover ratio will be.

#3 - Market Conditions

If the market conditions are favorable, the 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, the net worth becomes low, and the ratio becomes adverse as it only considers the shareholders’ fund or owned fund. The higher debt-equity ratio indicates that borrowing more finance sales. Also, proper legal compliance increases the market reputation, and investors’ attraction towards investment increases, which results in a higher capital turnover ratio.

Advantages

  • Optimum utilization of resources is possible as the capital is applied to earn the maximum revenue.
  • Ensures sufficient liquidity in the hands of the organization;
  • Ensures Increase in workforce 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 due to better management; 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.

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, non-monetary factors are to be balanced with monetary factors, 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

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, non-monetary factors are to be balanced with monetary factors, for example, satisfied stakeholders.