A Discussion of Capital Turnover

Working capital turnover is a measure to determine how effectively a company is using its assets to generate sales. The formula to determine working capital turnover is simple: Sales divided by Current Capital. For the purposes of this particular formula, current capital is found by subtracting current liabilities from current assets. Therefore, only a company's "positive" assets are used to determine its current working capital.

Capital Turnover Example

To understand working capital as a principle, imagine a very basic lemonade stand as a model. To set up the stand, two young children borrowed $10 for lemons. They also put $10 of their own allowance into the cost of painting a sign. The children's total current capital, the difference between their assets and debts, is $10. On the day of the lemonade stand, the children earned $40. Their working capital turnover was $40/$10, or 4. These children would have a higher working capital turnover than another lemonade stand that spent $5 of debt and $25 of personal money on supplies and only sold $50 of lemonade; this second stand would have a capital turnover of 2.5. With large companies offering stock, the numbers are much larger, often in the hundreds of millions. However, the model and measurements are the same. 

Importance of Capital Turnover

The smaller the current capital compared to the sales in this model, the higher the capital turnover ratio. This is important because in order to make the current capital figure smaller a company must go further into debt. Capital turnover, then, is a measure of how well a company is leveraging current assets to drive sales. The question is not how much the company owns or how much it sells. Instead, the question is how well a company turns what it owns into sales dollars. 

Capital Turnover as an Investment Analysis

If you are considering whether or not to invest in a company, thinking about its capital turnover can provide you with insight into how much money a company earns off of each dollar it already has. This is a very critical factor to a business's success; all business success is somehow based on the prospect of turning one dollar into several through sales techniques. By comparing the capital turnover of two companies, you can gain insight into which does this very simple thing better. All other things being equal, you should invest in the company with the higher capital turnover.

Limitations of Capital Turnover Measurements

The fact of the matter is that very rarely are all factors equal with two companies. Companies in different industries or with different seasonal operating models may have largely different capital turnover despite being in relatively similar financial healthy. On another note, if you were to make a decision based on working capital turnover alone, you would be neglecting to consider a company's ability to cover its liabilities, perhaps a greater concern. A company with a lot of debt may appear to have a high capital turnover but may be at risk of bankruptcy if even one downturn in sales did occur. 

blog comments powered by Disqus
Scottrade