Turnover Ratio Guide, Find the Formula, and How to Use It

The turnover ratio refers to the percentage of a mutual fund (or other types of investment holdings) that were replaced in a certain period (usually a year). Naturally, the indicator varies according to the investment objective, the type of mutual fund, as well as the portfolio manager’s investing style. Today we are going to focus on the formula for calculating this indicator and see why it’s important after all.

Types of Turnover Ratio

The term turnover ratio can refer to various indicators, depending on the result you want to find. Here you have the various types you can use:

1. Debtors or Accounts Receivables

This type of turnover ratio shows you how effectively the organization is collecting the money from the creditors for the goods they sell on credit. A high number indicates that the company collects it quickly. The formula here is:

Net credit sales  ÷ Average accounts receivable of the organization

2. Creditors or Accounts Payable

The second type measures how fast the company manages to pay the creditors for the goods they purchase on credit. A high ratio shows that the company pays the creditors fast, so you can assess the financial position of the company. The formula is:

Net credit purchase ÷ Average accounts payable of the company

3. Working Capital Turnover Ratio

When calculating the working capital turnover ratio, you will find out how well the company is using this type of capital to generate sales. Naturally, a higher result shows that the company is efficient. Calculate it with this formula:

Net sales ÷ Average working capital

4. Fixed Assets

The fourth type indicates how capable the company is to generate sales from the fixed assets investments. A higher ratio shows that the company uses the fixed asset to generate more sales. It is recommended you learn what is an asset turnover to be able to further calculate other important indicators. The formula here is:

Net sales ÷ Gross fixed asset

5. Current Assets

It is the indicator of the total sales the company has done with an investment in the current asset. The current assets represent stocks, cash, prepaid expenses, debtors, etc., and a higher ratio shows that the company uses them successfully. Calculate it like this:

Net sales ÷ Current sales

6. Inventory Turnover Ratio

The last turnover ratio type is the inventory one. We are going to analyze it in detail later, but for now, you should know that it shows the number of times the inventory or product of a company is sold in a year. Just like with the rest of the types, a higher result shows that the company can sell the products quickly and it has less dead stock. The basic formula is:

Cost of goods sold ÷ Average stock

The idea here is that all the types of turnover ratio help you have a clearer image of the company. It would be a mistake to consider only one indicator. Analyze all the ratios and see the current situation in detail.

How to Calculate the Inventory Ratio

This is one of the most popular calculations people do when it comes to their company. An alternative formula to find out this ratio is:

Sales ÷ Inventory

As we previously mentioned, it is recommended that you have a high ratio, which shows that more sales are being generated with a certain inventory. For a certain amount of sales, you can also use less inventory to improve this ratio. On the other hand, there can also be a very high inventory ratio that translates to lost sales if there isn’t enough inventory for the demand. Remember to compare your ratio to the industry benchmark to see if your company is successful.

Days Sales of Inventory (DSI)

Also called days inventory, the days sales of inventory represent the inverse of the inventory turnover ratio, which you then multiply by 365. The final formula looks like this:

(Average inventory ÷ Cost of goods sold) x 365

It’s an indicator that varies between industries, so it’s important to see how it stacks off against your rivals. For example, the businesses that sell perishable products, such as groceries, supermarkets, etc., will have a lower inventory days indicator than a business that is in the furniture industry.

Turnover Ratio Example

Let’s apply the theory to a concrete example. In the fiscal year 2016, Wal-Mart Stores Inc had annual sales that amounted to $482.13 billion. The yearly inventory totaled $44.47 billion, while the yearly cost of goods sold (also called cost of sales) was $360.98 billion. If we were to calculate the inventory turnover ratio, we would apply the formula above:

($360.98 billion ÷ $44.47 billion) = 8.12

At the same time, the days inventory calculation would look like this:

(1 ÷ 8.12) x 365 = 45 days

This translates to the fact that Wal-Mart sells all its inventory in a period of 45 days. The result is impressive, especially if you think about the fact they’re a large, global retailer.

Why Is Turnover Ratio Important?

Now that you found out all the formulas that help you calculate these important indicators, you may be wondering why should you even bother. You read above what is the purpose of each of the ratios and what it shows about the company. But why is the inventory turnover so important?

Often, a company has a huge amount of money locked in its own inventory. If the items it has there won’t get sold, the money won’t be available for paying the lenders, suppliers, employees, etc. There is also another possibility, for the inventory to become less in demand. It can deteriorate or become obsolete. If this happens, the company will lose its money. Because the inventory is such a delicate topic, it’s essential to calculate the turnover ratio and constantly assess the position of your company and money.

Here you have a clip explaining in detail how to calculate it and why is it so important:

To draw a conclusion, there are various types of turnover ratio. They help each entrepreneur or analyst see different parts of the company and figure out its success. Though the inventory turnover ratio is one of the most popular ones, it’s important to calculate all of them to have an opinion as accurate as possible. Use the formulas above to calculate the numbers and manage your resources correctly.

Image source: depositphotos.com

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