Turnover Ratios

Turnover ratios are financial ratios that measure how efficiently a business uses its assets or manages its obligations. Each one divides an income statement amount, such as sales or cost of goods sold, by the average balance of a related balance sheet account. A higher turnover generally means the business converts that resource into sales or cash more quickly.

Turnover ratios are also called activity or efficiency ratios. The most common are receivables turnover, inventory turnover, payables turnover, total asset turnover, fixed asset turnover and working capital turnover. They are often converted into a number of days, such as days sales outstanding, which many readers find easier to interpret. Analysts use them alongside liquidity, leverage and profitability measures as part of ratio analysis.

Imagine a lemonade stand that keeps about $50 worth of lemons and sugar on hand and sells $500 of lemonade over a month. Its stock has been used up and replaced about ten times. That is its turnover.

A stand that sells the same amount while holding $250 of supplies is tying up more money for the same result, and runs a greater risk of lemons going bad. Turnover ratios ask the same question about receivables, stock, equipment and every other resource: how hard is each dollar on the balance sheet working to produce sales?

The general form is:

The average is usually the beginning balance plus the ending balance, divided by two. A turnover ratio can be expressed in days with:

A wholesaler reports sales of $1,200,000 and cost of goods sold of $720,000. Its average accounts receivable are $150,000, average inventory $120,000, average accounts payable $60,000 and average total assets $800,000.

• Receivables turnover. $1,200,000 divided by $150,000 is 8.0 times, or about 45.6 days, the figure known as days sales outstanding. See the accounts receivable turnover ratio.
• Inventory turnover. $720,000 divided by $120,000 is 6.0 times, or about 60.8 days of days inventory outstanding. See the inventory turnover ratio.
• Payables turnover. $720,000 divided by $60,000 is 12.0 times, or about 30.4 days. Purchases are the better numerator, but cost of goods sold is often used when purchases are not disclosed.
• Total asset turnover. $1,200,000 divided by $800,000 is 1.5 times. See the asset turnover ratio.

Combining the day measures gives the cash conversion cycle: 45.6 plus 60.8 minus 30.4, or 76.0 days between paying suppliers and collecting from customers.

The numerator of a turnover ratio is a flow, built up over the whole period, while a balance sheet figure is a snapshot on one day. Averaging the opening and closing balances gives a fairer match between the two. Seasonal businesses, such as toy retailers that build stock before the holidays, often average monthly or quarterly balances instead, since a year-end balance can be unusually low. Consistency matters as much as precision: an analyst comparing two companies, or one company over several years, should calculate each ratio the same way each time, and should state which numerator and averaging method were used, because published ratio figures from different sources are often calculated differently.

There is no universal good turnover. Grocery stores turn inventory many times a year, while makers of heavy machinery turn it slowly. Utilities and telecom companies have low asset turnover because they own large networks, while service firms with few fixed assets have high asset turnover. Turnover ratios are most useful compared with a company's own history and with close competitors. In the DuPont breakdown, asset turnover multiplied by profit margin gives return on assets, showing whether returns come from efficiency or from pricing.

• Window dressing. Year-end collections or delayed purchases can flatter the balances used in the ratios.
• Accounting choices. A business using LIFO carries older, lower inventory costs in rising markets, which raises its inventory turnover compared with a FIFO user.
• Sales mix. Receivables turnover should use credit sales, but published figures often include cash sales.
• Aging assets. Heavily depreciated equipment raises fixed asset turnover without any real gain in efficiency.

Very high turnover is not always good either: it can point to stock shortages or credit terms so tight that sales are lost.

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