What is Capital Turnover?
Capital turnover is a measurement comparing an organization’s total annual sales to its stockholders’ equity.
“Capital turnover measures capital efficiency.” -Morgan Stanley Investment Management
Understanding Capital Turnover
Capital turnover demonstrates how effectively a company utilizes investor capital, also known as stockholder’s equity. Total annual sales of a company divided by stockholder’s equity demonstrates a company’s turnover ratio.
Total Annual Sales / Stockholder’s Equity (investor capital)
Furthermore, the ratio represents how much revenue a company can generate in comparison to capital invested in the company.
Turnover is higher in certain industries and lower in others. Service industries are often able to generate more revenue per dollar invested (high turnover) while mining industries often generate less revenue per dollar invested (low turnover).
Challenges with Capital Turnover
Many factors can limit the effectiveness of this approach including:
Capital Flows
The turnover ratio may vary tremendously at different points each year. A ratio may be high at one point in the year and low during another due to the varying nature of sales revenues and stockholders’ equity. Many industries employ this measurement concept to analyze revenue generation against invested capital, despite its limitations. In addition, it’s a tool companies often utilize to compare themselves against their competitors.
Profitability
A company’s turnover is primarily measured in relation to sales revenues and investor capital. In addition, the approach doesn’t consider the profitability of a business and the likelihood of its future existence.
Debt
Companies may incur debt by way of installment notes or other debt instruments to drive sales revenues higher. Incurring debt instead of acquiring additional investor equity can result in higher ratios yet with added risk.
Example
Tim’s coffee shop started in 2019.
- The company raised $100,000 in equity shares among investors that same year.
- By mid-2020 the company opened its first two retail locations.
- At the end of 2021, both locations had been open for a full calendar year.
- The two locations combined generated $700,000 in total annual sales in 2021.
To factor capital turnover, the following equation would be used:
Total Annual Sales / Shareholder’s Equity (investor capital)
$700,000 (does not include commission or interest income) / $100,000 (does not include liabilities) = 7
This outcome could be viewed as a 7:1 turnover ratio. Furthermore, for every $1 invested, the company generates $7 in revenue.
Additional Resources
For similar capital management concepts see:
