Equity Turnover Ratio

Equity turnover ratio is the ratio of the net sales of a company and the average equity a company holds over some time. This helps decide whether the company is creating enough revenues to make sure it is worth it for the shareholders to hold the company’s equity.

Also known as capital turnover, this ratio is one of the most important ratios used by an organization to find out how much revenue the shareholder’s equity can generate over a year. A higher ratio always indicates efficient use of equity capital to generate revenue.

• Equity turnover is a financial ratio that measures a company's ability to generate revenue from its shareholder equity. 
• It is calculated by dividing the company's net sales by its average equity. This ratio helps investors determine whether a company generates enough revenue to justify retaining its equity.
• The equity turnover ratio can vary widely depending on the capital intensity of the company's industry. 
• Industries that require significant investments in capital assets may have lower equity turnover ratios than those that require less capital investment.

An equity turnover ratio is a financial metric that helps firms know how effectively they utilize their shareholder’s equity. When the companies desire investors to invest in them, they must be aware of how they plan to utilize the resources. This ratio not only allows an investor to see how productively their investment would be used by the businesses, but also allows them to assess the level to which their contribution would help them.

The capital turnover ratio, once obtained, allows interested investors to assess the resultant and check if they can trust the firm. Normally, the businesses having serious profit or growth goals, they ensure the equity is used to the best possible extent. If there is a consistent pattern, indicating doubts, the investors understand there are chances of their investments being not fruitful to the desired extent. Hence, they may skip the company and look for firms or businesses having a more reliable equity turnover figure.

Most investors calculate this ratio before investing in the company because, through this ratio, they can understand how much they would directly affect the company’s revenue.

The equity turnover ratio may seem useful to the equity investors and even for the company, which is more equity capital intensive. But for the rest of the investors and companies, other ratios are more useful than equity turnover ratio, e.g., return on equity, return on investment, debt-equity ratio, inventory turnover ratio, etc. Like cash ratio, this ratio is also not being used much, but if you want to get a big picture of net sales and want to compare the net sales and the equity, you would be able to understand through this ratio.

The expression that helps calculate this ratio is as follows:

Equity Turnover Formula = Net Sales / Average Shareholders' Equity

Now the question is what you would consider as sales.

When you make sales, it is net sales, not gross sales. A gross sale is a figure inclusive of the sales discount and sales returns. We would take the net sales, which means we must exclude sales discount and sales returns (if any) from the gross sales to get the right figure.

To calculate the average shareholders' equity, we need to consider the shareholders' equity at the beginning of the year and end. And then, we would find the mean of the sum of the total equity (beginning + end).

You may also like - Ratio Analysis Definition Excel Based Comprehensive Analysis

It isn't easy to interpret the Equity Turnover Ratio. But if you take a general perspective, an increased proportion provides a positive indication, and a decreased proportion indicates a negative connotation.

However, there are a couple of things about the ratio we need to pay heed to. Let’s have a look at them –

• The equity turnover ratio varies greatly depending on the industry's capital intensive. For example, if we consider the turnover ratio of the oil refinery industry, it would be much less than a service business; because the oil refinery needs large capital investment to generate sales. So the comparison of ratios should be made among companies that belong to the same industry.
•  If any company wants to increase the equity turnover ratio to attract more shareholders, it may skew the equity by increasing the debt percentage in the capital structure. This move is very risky as by doing this, the organization is taking on the burden of too much debt, and eventually, they have to pay the debt with interest.

Let us consider the following example to understand the concept and its calculation better:

Let’s do the calculation to determine the equity turnover ratio for both companies.

First, as we have been given Gross Sales, we need to calculate the Net Sales for both companies.

And as we have the equity at the beginning of the year and the end of the year, we need to find out the average equity for both companies.

Now, let’s calculate the equity turnover ratio for both companies.

As mentioned before, if these companies are from similar industries, we can compare the turnover ratio of both of them. For Company A, the equity turnover ratio is more than Company B. That doesn’t mean Company A is doing much better than Company B. It just means that somehow from the ratio, we can conclude that Company A can generate better revenue out than their average shareholders' equity than Company B.

It may happen that Company A has reduced the percentage of equity in the capital structure by increasing the debt to attract more shareholders. In that case, the increased proportion doesn’t indicate a positive result.

Let’s look at the income statement first, and then we would have a glance at their balance sheet for the years 2014 and 2015.

Consolidated income statement for the year ended 31^st December 2014 & 2015

A consolidated balance sheet as of 31^st December 2014 & 2015

source: Nestle 2015 Financial Statements

Now let’s calculate the equity turnover ratio of Nestle for the years 2014 & 2015.

As Nestle  belongs to the FMCG industry, revenue and equity are almost equal. We can say the FMCG sector is very much capital intensive. But what is the oil refinery industry? Is the industry capital intensive? What would be the equity turnover ratio of the oil refinery industry? Let’s have a look.

In this section, we will pull out a few data from the Indian Oil Corporation’s annual report, and then we will calculate the equity turnover ratio for the years 2015 and 2016.

First, let’s look at the revenue of Indian Oil Corporation for the year ended 31^st March 2016.

Let’s have a glance at the share capital of Indian Oil Corporation for the year ended 31^st March 2016.

source: IOC annual reports

As Indian Oil Corporation is a very capital-intensive corporation, the turnover is around five and more. But let's say we are calculating the equity turnover of a service industry where the need for capital investment is much lesser; in that case, the turnover would be much more.

Home Depot is a retail supplier of home improvement tools, construction products, and services. It operates in the US, Canada, and Mexico.

When we look at Home Depot's Equity turnover, we see that until 2012, turnover was relatively stable at around 3.5x. However, since 2012, Turnover of Home Depot has started climbing steeply and currently stands at 11.32x (growth of around 219%)

What are the reasons for such an increase -

source: ycharts

Equity turnover can increase either because of an increase in sales, a decrease in equity, or both.

# 1 - Evaluating Home Depot's Increase in Sales

Home Depot Sales increased its revenue from $70.42billion to $88.52, an increase of approximately 25% in 4 years. This increase of 25% in 4 years has contributed to the increase in turnover; however, its contribution is somewhat restricted.

source: ycharts

#2 - Evaluating Home Depot's Shareholder's Equity

We note that the shareholder's equity of Home Depot has decreased by 65% in the last four years. It means the denominator has been reduced by more than half.

source: ycharts

If we look at Home Depot’s Shareholder’s Equity section, we find the possible reasons for such a decrease.

1. Accumulated Other Comprehensive Loss has resulted in lowering shareholders' equity in both 2015 and 2016. It stood at -818 million in 2016 and -452 in 2015. Accumulated other comprehensive losses are adjustments primarily related to foreign currency translations.
2. Accelerated Buybacks were the second and most important reason for the decrease in Shareholder’s equity in 2015 and 2016. We note that Home Depot bought back 520 million shares (approximately $33.19 billion) and 461 million shares (~ value $26.19 billion) in 2016 and 2015, respectively.

Here are some of the top companies by market capitalization and equity turnovers. We note that Boeing has a turnover of 26.4x.

source: ycharts

source: ycharts

• Internet companies have low turnovers. We note that the average Equity Turnover of the top internet companies is 1.0x
• Alphabet (Google) turnover is 0.7x, while that of Facebook is 0.5x

source: ycharts

• Oil & Gas companies have low turnovers. We note that the average Equity Turnover of the top Oil & Gas EP companies is 0.5x
• Devon Energy has an above-average equity turnover of 0.9x
• Concho Resources has a below-average equity turnover of 0.3x

source: ycharts

• Restaurant companies have a higher equity turnover. The average turnover of top restaurant-based companies is 4.6x
• Please note that Domino's Pizza has a negative turnover of -1.5x
• Dunkin Brands, on the other hand, has an above-average turnover of 11.0x

source: ycharts

• Like internet companies, Software application companies also have equity turnover closer to 1x. The top 10 companies in software applications have an average turnover of 1.4x

Negative Turnover arises when the Shareholder’s Equity becomes negative.

source: ycharts

• Kimberly Clark has a negative equity turnover of -131.9x
• Marriott International has a negative turnover of -5x

Calculating the equity turnover ratio is highly beneficial for firms and stakeholders associated with it. Let us have a quick look at the advantages of the same below:

• It is one of the significant ways of raising funds to establish, expand, and support a business operation.
• When the ratio is positive, the investors know that the shareholders’ equity is being used efficiently by the company. Hence, they trust these companies while investing the next time as well.
• When the ratio obtained shows a low value, the companies become alert and adopt new measures to use the equity in a better and more efficient manner.

Even if the Equity Turnover Ratio can be helpful for shareholders before investing in a company, this ratio has some limitations that the potential investors and the company, which is calculating the ratio, should keep in mind.

• The equity turnover ratio can be manipulated if the company wants to attract more investors. By changing the company's capital structure (by injecting more debt into the capital), the company can change the turnover ratio altogether, which the investors may not understand all too well.
• Equity always doesn’t generate revenue. If we would like to know the specific relationship between equity and revenue, there would be hardly anything to compare. However, it's far more valid if we compare equity with net income.
• The equity turnover ratio is not applicable for a company that mainly focuses on debt for its capital necessity. Though it’s always advisable for a company to go for more equity and less debt, many companies find it useful to take debt instead of equity options.

This article has been a guide to what is Equity Turnover Ratio. Here, we explain it with formula, interpretation, examples, benefits, and limitations. You may also have a look at the following related article:

• Asset Turnover Ratio 
• Cash Conversion Cycle
• Capital Gearing Ratio
• Working Capital Ratio