Equity turnover is a ratio that measures the proportion of a company's sales to its stockholders' equity. The intent of the measurement is to determine the efficiency with which management is using equity to generate revenue.
The calculation of equity turnover is:
Annual net sales ÷ Average stockholders' equity
In order to conduct this calculation on a monthly basis, use the trailing 12 months' sales figure in the numerator, and match it to the average stockholders' equity during the same period. For a more accurate outcome, use the weighted average stockholders' equity for the measurement period.
As an example of the equity turnover calculation, a business generates $1,000,000 of sales over a one-year period. During that time, the organization maintains an average equity balance of $200,000. Based on this information, the company has a 5:1 equity turnover ratio, which is calculated as:
$1,000,000 Annual net sales ÷ $200,000 Average stockholders' equity
There are a number of issues to consider when using this measurement, which are:
- The ratio varies substantially, depending on how capital-intensive an industry may be. Thus, an oil refining business may have a much lower ratio than a services business, since the refinery business requires a much larger capital investment. Thus, if the measurement is being used to compare the performance of different companies, only do so for companies located in the same industry.
- Company management can skew the ratio in their favor by using more debt instead of equity. Doing so will increase the ratio, but can place a business in serious jeopardy if margins fall, since the organization will no longer be able to pay its debts.
- The ratio assumes that the key company improvement standard is revenues, when it fact it is usually more important to generate cash flow or profits. Thus, the ratio may place an emphasis on the wrong target.
Equity turnover is also called capital turnover.