What are Turnover Ratios?
A turnover ratio represents the amount of assets or liabilities that a company replaces in relation to its sales. The concept is useful for determining the efficiency with which a business utilizes its assets. In most cases, a high asset turnover ratio is considered good, since it implies that receivables are collected quickly, fixed assets are heavily utilized, and little excess inventory is kept on hand. This implies a minimal need for invested funds, and therefore a high return on investment. Conversely, a low liability turnover ratio (usually in relation to accounts payable) is considered good, since it implies that a company is taking the longest possible amount of time in which to pay its suppliers, and so retains its cash for a longer period of time. Examples of turnover ratios are noted below.
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Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures the time it takes to collect an average amount of accounts receivable. It can be impacted by the corporate credit policy, payment terms, the accuracy of billings, the activity level of the collections staff, the promptness of deduction processing, and a multitude of other factors.
To calculate receivables turnover, add together beginning and ending accounts receivable to arrive at the average accounts receivable for the measurement period, and divide into the net credit sales for the year. The formula is as follows:
Net Annual Credit Sales ÷ ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)
Inventory Turnover Ratio
The inventory turnover ratio measures the amount of inventory that must be maintained to support a given amount of sales. It can be impacted by the type of production process flow system used, the presence of obsolete inventory, management's policy for filling orders, inventory record accuracy, the use of manufacturing outsourcing, and so on.
To calculate inventory turnover, divide the ending inventory figure into the annualized cost of sales. If the ending inventory figure is not a representative number, then use an average figure instead, such as the average of the beginning and ending inventory balances. The formula is:
Annual cost of goods sold ÷ Inventory= Inventory turnover
Fixed Asset Turnover Ratio
The fixed asset turnover ratio measures the fixed asset investment needed to maintain a given amount of sales. It can be impacted by the use of throughput analysis, manufacturing outsourcing, capacity management, and other factors.
The formula for the ratio is to subtract accumulated depreciation from gross fixed assets, and divide that amount into net annual sales. The formula is:
Net annual sales ÷ (Gross fixed assets - Accumulated depreciation) = Fixed asset turnover ratio
Accounts Payable Turnover Ratio
The accounts payable turnover ratio measures the time period over which a company is allowed to hold trade payables before being obligated to pay suppliers. It is primarily impacted by the terms negotiated with suppliers and the presence of early payment discounts.
To calculate the accounts payable turnover ratio, summarize all purchases from suppliers during the measurement period and divide by the average amount of accounts payable during that period. The formula is:
Total supplier purchases ÷ ((Beginning accounts payable + Ending accounts payable) / 2)
Investment Fund Turnover
The turnover ratio concept is also used in relation to investment funds. In this context, it refers to the proportion of investment holdings that have been replaced in a given year. A low turnover ratio implies that the fund manager is not incurring many brokerage transaction fees to sell off and/or purchase securities. The turnover level for a fund is typically based on the investment strategy of the fund manager, so a buy-and-hold manager will experience a low turnover ratio, while a manager with a more active strategy will be more likely to experience a high turnover ratio and must generate greater returns in order to offset the increased transaction fees.
