Capital Turnover
Capital turnover, also known as asset turnover or capital employed turnover, is a financial efficiency ratio that measures how effectively a company utilizes its total capital or assets to generate revenue. It indicates the amount of revenue generated per dollar of capital employed or assets owned by the company. A higher capital turnover ratio signifies that the company is using its capital more efficiently to generate sales, while a lower ratio may suggest that the company is not utilizing its capital as effectively.
The capital turnover ratio can be calculated using the following formula:
Capital Turnover = Revenue / Average Capital Employed
Where:
- Revenue is the total sales or revenue generated by the company during a specific period, usually a fiscal year.
- Average Capital Employed is the average of the company’s total capital at the beginning and end of the period. Capital employed is the sum of shareholders’ equity and total debt, or it can be calculated as total assets minus current liabilities, depending on the definition used.
Capital turnover is an important metric for evaluating a company’s operational efficiency and overall financial performance. It can be particularly useful for comparing companies within the same industry or sector, as it helps to identify firms that are generating more sales per dollar of capital employed. However, it’s important to consider other financial metrics and ratios when assessing a company’s performance, as capital turnover alone does not provide a complete picture of its financial health or efficiency.
Keep in mind that the capital turnover ratio may vary significantly between industries or sectors, as different types of businesses require different levels of capital investment. For example, a capital-intensive industry like manufacturing may have a lower capital turnover ratio than a service-based industry with lower capital requirements.
Example of Capital Turnover
Let’s consider two fictional companies, TechWave Inc. and GreenGrow Inc., to illustrate the concept of capital turnover.
TechWave Inc. is a technology company with the following financial information:
- Revenue: $10,000,000
- Beginning capital employed: $4,000,000
- Ending capital employed: $5,000,000
GreenGrow Inc. is an organic food company with the following financial information:
- Revenue: $8,000,000
- Beginning capital employed: $2,500,000
- Ending capital employed: $3,000,000
Now, let’s calculate the capital turnover ratio for each company:
- TechWave Inc.:
- Average capital employed: ($4,000,000 + $5,000,000) / 2 = $4,500,000
- Capital turnover: $10,000,000 (revenue) / $4,500,000 (average capital employed) = 2.22
- GreenGrow Inc.:
- Average capital employed: ($2,500,000 + $3,000,000) / 2 = $2,750,000
- Capital turnover: $8,000,000 (revenue) / $2,750,000 (average capital employed) = 2.91
Based on these calculations, GreenGrow Inc. has a higher capital turnover ratio (2.91) compared to TechWave Inc. (2.22). This suggests that GreenGrow Inc. is using its capital more efficiently to generate revenue than TechWave Inc.
However, it’s essential to consider other factors and financial metrics when comparing these companies, as capital turnover alone does not provide a complete picture of their financial performance or efficiency. For example, the companies may have different levels of profitability, risk, or growth potential, which could impact their overall attractiveness as investments.
