Capital turnover compares the annual sales of a business to the total amount of its stockholders' equity. The intent is to measure the proportion of revenue that a company can generate with a given amount of equity. It is also a general measure of the level of capital investment needed in a specific industry in order to generate sales. For example, capital turnover is very high in most services industries, and much lower in the more asset-intensive oil refining industry. As an example of the calculation, if a company has $20 million of sales and $2 million of stockholders' equity, then its capital turnover is 10:1.
There are a number of problems with the capital turnover concept that limit its use. These issues are:
- Leverage. A company may incur an excessive amount of debt to fund additional sales, rather than acquiring more equity. The result is high capital turnover, but at an increased risk level.
- Profits. The ratio ignores whether a company is generating a profit, concentrating instead on the generation of sales.
- Cash flow. The ratio ignores whether a company is generated any cash flow.
- Changes in capital. The capital turnover ratio is usually made as of a specific point in time, when the amount of capital may be unusually high or low in comparison to any of a number of points in time prior to the measurement date. This can yield an unusually high or low turnover ratio. The problem can be mitigated by using an average equity figure in the denominator.
Given these issues, valid usage of the capital turnover concept is certainly limited. At best, it can be employed to examine asset investment levels across an entire industry, to gain a general idea of which competitors appear to be making better use of their equity.
Capital turnover is also called equity turnover.