What is Capital Turnover?
Capital Turnover is a financial ratio that measures the efficiency at which a company can utilize its equity funding to generate sales.
How to Calculate Capital Turnover (Step-by-Step)
The capital turnover metric estimates the operating efficiency of a company via its allocation of equity capital.
Expressed as a formula, capital turnover is the ratio between a company’s net sales and the average shareholders’ equity across a specified period.
- Net Sales: The net sales of a company is the starting line item on the income statement that represents the total monetary value earned from the sale of goods and services in a specified period.
- Shareholders’ Equity: On the balance sheet, the shareholders’ equity section contains accounts like the owner’s equity (i.e. initial contribution), proceeds from the issuance of common stock or preferred stock, additional paid-in capital (APIC), and retained earnings.
Conceptually, the capital turnover therefore measures the proportion of a company’s sales generated per dollar of equity contribution.
The calculation of the capital turnover ratio is a three-step process:
- Step 1: Determine Net Sales in Specified Period
- Step 2: Calculate Average Shareholders’ Equity (i.e. Beginning of Period and End of Period Equity Balance Divided by Two)
- Step 3: Divide Net Sales by Average Shareholders’ Equity
Capital Turnover Formula
The formula to calculate capital turnover is as follows.
Sales represent the “top line” of the income statement line, while inventory is found in the current assets section of the balance sheet.
Thus, there is a mismatch between the time period covered in the numerator and denominator.
- Income Statement: The income statement, or “profit and loss statement”, measures a company’s operating performance over a given period.
- Balance Sheet: The balance sheet portrays the value of a company’s assets, liabilities, and equity as of a specific date (i.e. “snapshot”).
The use of the average shareholders’ equity is an imperfect compromise to fix the mismatch in timing, yet it is a more accurate approach in comparison to simply using the ending balance.
However, the marginal improvement in accuracy is negligible in most cases, i.e. the insights derived, in all likelihood, will be nearly identical whether the average or ending balance is used in the formula.
How to Interpret Capital Turnover Ratio (High or Low)
The capital turnover ratio is a method not only to understand a company’s operating efficiency but also the upside with regard to its growth potential.
In general, a higher capital turnover ratio corresponds to greater upside in terms of revenue growth and profitability (and vice versa for lower ratios).
However, there are some pitfalls to the ratio that must be considered.
- Capital Intensity: The capital intensity of the industry the company operates in is a critical factor that impacts the capital turnover ratio. For instance, the turnover ratio tends to be much higher for service-oriented companies (e.g. consulting) relative to those with asset-heavy business models (e.g. manufacturing).
- Debt in Capital Structure (%): The capital turnover ratio can also be artificially inflated from the company relying more on debt financing to fund its operations and growth strategies, as opposed to equity financing. In such a case, the company is not necessarily more efficient at utilizing its equity, but it is instead adding more leverage to its capital structure, which introduces greater credit risk.
Capital Turnover Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Capital Turnover Calculation Example
Suppose we’re tasked with calculating the capital turnover ratio for a manufacturer with the following income statement and balance sheet data.
|Selected Financial Data||2020A||2021A||2022A|
|Net Sales||$100 million||$125 million||$150 million|
|Total Shareholders’ Equity||$60 million||$62 million||$64 million|
Starting off, we’ll determine the average shareholders’ equity balance for our historical periods.
- Average Shareholders’ Equity, 2020 to 2021 = $61 million
- Average Shareholders’ Equity, 2021 to 2022 = $63 million
The sales of a company over the course of the three-year historical period were provided as assumptions, i.e. $100 million, $125 million and $150 million.
Our next step is to divide the sales from each period by the corresponding average shareholders’ equity balance to calculate the capital turnover.
Once completed, we arrive at a historical capital turnover ratio of 2.0x and 2.4x, which by itself, implies that the company is becoming more efficient over time at generating revenue per dollar of equity.
- Capital Turnover Ratio, 2020 to 2021 = 2.0x
- Capital Turnover Ratio, 2021 to 2022 = 2.4x