Definition
Capital turnover is a financial efficiency ratio that measures how effectively a company uses its capital to generate revenue. It is calculated by dividing the company’s annual sales or revenue by its total equity or capital. A higher capital turnover ratio indicates more efficient use of capital in generating revenue.
Key Takeaways
- Capital Turnover is a financial efficiency ratio which shows a company’s ability to generate sales from its capital investments. This is done by comparing a company’s annual sales to its total shareholders’ equity. The higher the ratio, the better, as it signals that the company is efficient at using its capital to generate sales.
- Capital Turnover provides a key indicator of financial performance and health, shedding light on a company’s operational efficiency. A low turnover ratio may indicate under-utilized resources or infrastructure, while a high ratio indicates efficient use of capital.
- While Capital Turnover is a valuable metric to determine the profitability and efficiency of a company, it should not be used in isolation. It’s important to compare this ratio with peer companies in the same industry and to look at other financial ratios to get a complete picture of a company’s financial performance.
Importance
Capital Turnover is a critical financial metric as it directly relates to the efficiency with which a company uses its capital to generate revenue.
It offers insights into the operational efficiency of the business model, examining how well a company uses its fixed assets and working capital to produce sales.
If the capital turnover ratio is high, it implies the company is efficient at using its capital to generate sales.
Conversely, a low ratio could indicate underused resources or poor sales performance.
Therefore, by monitoring capital turnover, businesses can identify areas of inefficiency or underperformance and initiate strategies to optimize use of their capital.
Explanation
Capital turnover is a key efficiency ratio that measures how a company utilizes its capital investments to drive revenue. This metric is significant as it assists businesses, investors, and analysts in understanding how effectively the company is using its capital to generate sales, and as such, it becomes an important tool for evaluating the company’s operational efficiency.
A high capital turnover ratio typically signals that the company is efficient at using its capital to generate sales, while a low ratio could indicate the opposite. In business strategizing and investment decisions, the capital turnover is particularly useful.
For instance, comparing the capital turnover ratios of different companies within the same industry can give insights into which companies are more efficient at generating revenue from their capital investments. This can be helpful for potential investors who are looking for efficient companies to invest in.
Companies are also able to use this ratio to identify areas where they might improve efficacy, such as lowering their operational costs or investing more strategically.
Examples of Capital Turnover
Capital turnover is measured by taking the total sales of a company over a specified period and dividing it by the company’s total capital employed. Here are three real-world examples:
Amazon Inc.: Amazon has a relatively high capital turnover ratio. This is primarily due to its business model that focuses on inventory turnover and efficiency. With a low amount of tangible assets (like buildings and equipment) compared to its high sales revenue, Amazon effectively uses its capital to generate sales.
General Motors (GM): As a manufacturing company, GM has a substantial amount of capital tied up in property, plants, and equipment. However, if GM were to have a year where their sales were low but they still had high levels of capital in these assets, the capital turnover ratio would be low indicating that the company is not effectively turning its capital into revenue.
Tesco PLC: As a supermarket chain, Tesco may have a moderate capital turnover ratio. For instance, if it generates £80 billion in sales annually, and the total capital employed is £40 billion, the capital turnover would be
This means Tesco could reach its sales goal with the invested capital and does a decent job transforming its capital into sales.
FAQs on Capital Turnover
What is Capital Turnover?
Capital Turnover refers to the ratio that measures the efficiency with which a company uses its capital to generate revenue. It is calculated by dividing the company’s annual sales by the average capital employed during the same year. This ratio is used to evaluate how well a company is utilizing its capital to create more revenue.
How is Capital Turnover calculated?
The Capital Turnover can be calculated by using the following formula: Capital Turnover = Total Sales / Average Capital Employed. The average capital employed is calculated by adding the beginning and ending capital for the year, then dividing by two.
What does a high Capital Turnover ratio mean?
A high Capital Turnover ratio suggests that a company is using its capital efficiently to generate sales and revenue. This can be a positive sign indicating the effectiveness of the company’s operations and investment strategies. However, it is also important to compare this ratio with other similar businesses to get a more accurate understanding.
What does a low Capital Turnover ratio mean?
A low Capital Turnover ratio may indicate that a company is not capitalizing efficiently on its assets to generate sales and revenue. It could either mean the organization has underutilized assets or the company’s strategy is not effective. The company may need to review its asset utilization and sales strategies.
Is a high Capital Turnover always good?
While a high Capital Turnover ratio typically reflects efficient use of assets, it’s not always a good sign. If the turnover is too high, it suggests that the company might be overworking its assets, which can lead to wear and tear, inefficiencies and increases costs in the long run. Therefore, an optimal balance should be maintained.
Related Entrepreneurship Terms
- Working Capital: The amount of money a company has available to manage its day-to-day operations. It’s computed by subtracting current liabilities from current assets.
- Asset Turnover Ratio: A financial metric that indicates the efficiency of a company in using its assets to generate sales.
- Return on Investment (ROI): Measures the gain or loss made on an investment relative to the amount of money invested.
- Earnings Before Interest and Taxes (EBIT): Indicator of a company’s profitability, calculated as revenue minus expenses, excluding tax and interest.
- Gross Profit Margin: A company’s total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage.
Sources for More Information
- Investopedia – a comprehensive website covering all aspects of finance including the term Capital Turnover.
- The Balance – another useful finance related website explaining a variety of financial indicators including Capital Turnover.
- Accounting Tools – an informative website about accounting data and financing terms like Capital Turnover.
- Corporate Finance Institute – a professional platform providing detailed researches and explanations about various finance concepts including Capital Turnover.
