"It takes money to make money" is a cliché in the business world, but it points to a very real issue that businesses – regardless of size – must contend with. Investors and a company's management need a way to estimate how much capital is needed to produce growth in sales. A capital turnover ratio measures how capital-intensive a business's existing operations are, and therefore provides insight into future capital requirements.
Capital Turnover Ratio
A capital turnover ratio, also called equity turnover ratio, measures the net sales a company generates as a proportion of the amount invested. This measure assesses how efficiently a company utilizes its capital. Generally, a high capital turnover ratio suggests a business is using its capital resources efficiently.
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It's important to note that capital turnover varies by industry. For example, a retailer is likely to have a higher capital turnover ratio than a manufacturer because manufacturing typically requires more equipment and capital investment. For this reason, determining whether a particular company has a good capital turnover ratio requires comparing it to other firms in the same industry.
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Measuring Capital Turnover
To calculate capital turnover, divide the company's yearly sales by the shareholders' equity. The sales figure is listed on the company's income statement and you can find shareholders' equity on the balance sheet. Both financial statements are part of a firm's annual report. Suppose a corporation has $15 million in sales and $4 million in shareholders' equity. Dividing out, you get a capital turnover ratio of 3.75:1.
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Issues With Capital Turnover
One way of looking at the capital turnover ratio is to tell you how many dollars of sales you can expect from a dollar of capital. A 3.75:1 ratio means $1 of investment capital will produce $3.75 in annual sales. However, this does not tell you anything about the profitability of the business. Another limitation of capital turnover is that it ignores the impact of borrowed capital, even though a significant portion of the annual sales may be generated by assets acquired by taking on debt such as loans.
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A Variation on Capital Turnover
An alternative approach to calculating capital turnover uses the total capital invested rather than shareholders' equity alone. Using this variation, divide a company's total assets, meaning equity plus liabilities, into sales. For example, Company C has $15 million in sales, $4 million of shareholders' equity and $4 million in liabilities. Divide $15 million by $8 million capital invested and you get a capital turnover of 1.88:1.
The advantage of this method is that it factors in borrowed capital and provides a more accurate assessment of how capital-intensive the business actually is.