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Turnover in Business: What It Is, Importance

What is Turnover?

Turnover measures how quickly a company replaces its assets within a specific period, encompassing activities such as selling inventory, collecting receivables, or replacing employees. In investment terms, it refers to the percentage of a portfolio that is replaced.

The definition of turnover can vary depending on the context. For example, in Europe and Asia, turnover is often synonymous with a company’s total revenues.

Key points:

  • Turnover is an accounting concept that measures the speed at which a business conducts its operations.
  • The most common measures of corporate turnover focus on accounts receivable and inventory.
  • Accounts Receivable Turnover indicates how quickly a company collects payments compared to its credit sales during a specific period.
  • Inventory Turnover is calculated by dividing the cost of goods sold (COGS) by the average inventory, demonstrating how fast a company sells its inventory within a given period.
  • In the investment industry, turnover refers to the percentage of a portfolio that is sold within a particular month or year.

Understanding Turnover

Turnover ratios calculate how quickly a business conducts operations, measuring efficiency and resource utilisation.

Two of a business’s largest assets are typically accounts receivable and inventory, if maintained. These accounts require significant cash investment, making it crucial to measure how quickly a business collects cash. Turnover ratios help fundamental analysts and investors determine if a company is managing its finances and assets effectively.

Common types of turnover ratios include:

  • Accounts receivable turnover
  • Inventory turnover
  • Portfolio turnover
  • Asset turnover

By examining a range of these ratios, companies can better assess their operational efficiency. Optimal turnover ratios vary: a low accounts receivable turnover ratio might indicate issues with collection procedures or credit policies, while a high inventory turnover ratio in the same retail company could signal strong sales.

Types of Business Turnovers

Turnovers in the business circuit can be classified into four categories, shown in the following.

Accounts Receivable Turnover

Accounts receivable represents the total dollar amount of unpaid customer invoices at any given time. Assuming that credit sales are sales not immediately paid in cash, the accounts receivable turnover formula is calculated as credit sales divided by average accounts receivable. The average accounts receivable is the average of the beginning and ending accounts receivable balances for a specific period, such as a month or a year.

The accounts receivable turnover ratio indicates how quickly a company collects payments from its credit sales. For example, if monthly credit sales total $300,000 and the accounts receivable balance is $50,000, then the turnover rate is six. The goal is to maximise sales, minimise the receivable balance, and achieve a high turnover rate.

Accounts payable turnover, calculated as cost of goods sold divided by average accounts payable, is a short-term liquidity measure that assesses the rate at which a company pays back its suppliers and vendors.

Inventory Turnover

Similarly structured, the inventory turnover formula, expressed as cost of goods sold (COGS) divided by average inventory, parallels the accounts receivable formula.

Upon selling inventory, the balance shifts to the cost of sales, an expense account. Business owners aim to optimise inventory sold and reduce leftover inventory, avoiding larger overhead costs. For example, if the monthly cost of sales tallies $400,000 against a $100,000 inventory, the turnover rate stands at four, indicating a company cycles through its entire inventory four times annually.

Inventory turnover, also termed sales turnover, aids investors in assessing the risk level when providing operating capital to a company. Retailers often boast higher inventory turnover. The swiftness might typify industry norms or indicate a well-managed company.

For instance, a company with a $5 million inventory taking seven months to sell would be considered less profitable than a company with a $2 million inventory sold within two months. 

Portfolio Turnover

Portfolio turnovers quantifies the percentage of an investment portfolio liquidated within a specific timeframe.

Consider a scenario where a mutual fund manages assets worth $100 million and the portfolio manager sells securities amounting to $20 million over a year. The turnover rate computes as $20 million divided by $100 million, resulting in a 20% turnover ratio. This ratio implies that the traded value represents one-fifth of the fund’s total assets.

Actively managed portfolios tend to exhibit higher turnover rates, while passively managed ones might involve fewer trades in a year. However, the former incurs more trading costs, potentially diminishing the portfolio’s overall return. Investment funds with excessive turnover are often perceived as lower quality.

Asset Turnover

The asset turnover ratio gauges a company’s sales or revenue against its asset value. It serves as an indicator of how efficiently a company leverages its assets to generate revenue.

The formula is as follows:

Asset Turnover = (Total Sales ÷ (Beginning Assets + Ending Assets)) ÷ 2

where:

Total Sales = Annual sales total

Beginning Assets = Assets at start of year

Ending Assets = Assets at end of year

A higher asset turnover ratio signifies superior efficiency in converting assets into revenue. Conversely, a low asset turnover ratio implies inefficiency in using assets to drive sales.

FAQs

Why is high turnover bad for mutual funds?

Increased turnover rates directly correlate to higher turnover. Elevated turnover rates lead to amplified fund expenses, potentially diminishing the fund’s overall performance. Moreover, higher turnover rates can yield adverse tax implications. Funds with elevated turnover rates often face CGT, subsequently distributed to investors who may be liable to pay taxes on those gains.

What is the difference between turnover and profit?

While both turnovers and profits are critical finance metrics, they serve different purposes and generate different output:

Turnovers measure the total revenue generated by a business during a specific period, providing insight into its sales performance and revenue-generating capabilities.

Profits, on the other hand, represent the net income remaining after deducting all expenses, including operating costs, taxes, and interest. Profits reflect the financial health of a company, indicating whether it’s profitable after considering all costs.

In essence, turnovers are a key driver of profits, but don’t directly reveal a company’s profitability since they don’t account for expenses.

Turnover Trends in Australia

In the Australian context, turnovers are vital for businesses operating in diverse industries, from retail to services and manufacturing. They play a significant role in economic analysis, serving as key data points for assessing market trends, business competitiveness, and overall financial stability.

To underline turnovers’ importance in the Australian economy, the ABS evaluated the month-on-month turnover performance of 13 industries for August 2023. The agency found that eight of those industries did well in incremental growth up from July – manufacturing (6.4 per cent), arts and recreation (six per cent), retail (3.6 per cent), professional, scientific and technical services (1.9 per cent), dining and hospitality (1.1 per cent), wholesalers (one per cent), mining (0.9 per cent), and transport, postal and warehousing (0.3 per cent).

Conclusion

Turnover can refer to both an accounting and an investing concept. In accounting, it measures the speed at which a business conducts its operations. In investing, it refers to the percentage of a portfolio that is sold within a specific period.

A business typically measures various types of turnover, with inventory turnover and accounts receivable turnover being the most common. Accounts receivable turnover indicates how quickly a business collects payments from its customers. Inventory turnover indicates how quickly a company sells through its entire inventory. Both metrics can be used by investors to assess the efficiency of a company’s operations.

DISCLAIMER: This article is for informational purposes only and the opinion of the author. BARTERCARD has no business affiliations with any mentioned company or organisation.

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