What Is Turnover in Business, and Why Is It Important?

What Is Turnover?

Turnover is an accounting concept that calculates how quickly a business conducts its operations. Most often, turnover is used to understand how quickly a company collects cash from accounts receivable or how fast the company sells its inventory.

Common forms of turnover include accounts receivable turnover, inventory turnover, portfolio turnover, and working capital turnover. Companies can better assess the efficiency of their operations through looking at a range of these ratios, often with the goal of maximizing turnover.

In the investment industry, turnover is defined as the percentage of a portfolio that is sold in a particular month or year. A quick turnover rate generates more commissions for trades placed by a broker.

Overall turnover is a synonym for a company’s total revenues. It is commonly used in Europe and Asia.

KEY TAKEAWAYS

• Turnover is an accounting concept that calculates how quickly a business conducts its operations.
• The most common measures of corporate turnover look at ratios involving accounts receivable and inventories. These are called accounts receivable turnover and inventory turnover.
• Accounts receivable turnover shows how quickly payments are being collected compared with credit sales during a certain time period, such as a month or a year.
• Inventory turnover is calculated by taking the cost of goods sold (COGS) divided by average inventory, showing how fast a company sells its inventory in a given time period.
• In the investment industry, turnover is defined as the percentage of a portfolio that is sold in a particular month or year.

Understanding Turnover

Two of the largest assets owned by a business are accounts receivable and inventory. Both of these accounts require a large cash investment, and it is important to measure how quickly a business collects cash.

Turnover ratios calculate how quickly a business collects cash from its accounts receivable and inventory investments. These ratios are used by fundamental analysts and investors to determine if a company is deemed a good investment.

What Is Accounts Receivable Turnover?

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

The accounts receivable turnover formula tells you how quickly you are collecting payments, compared with your credit sales. For example, if credit sales for the month total $300,000 and the account receivable balance is $50,000, then the turnover rate is six. The goal is to maximize sales, minimize the receivable balance, and generate a large turnover rate.

Similarly, accounts payable turnover (sales divided by average payables) is a short-term liquidity measure that measures the rate at which a company pays back its suppliers and vendors.

What Is Inventory Turnover?

The inventory turnover formula, which is stated as the cost of goods sold (COGS) divided by average inventory, is similar to the accounts receivable formula.

When you sell inventory, the balance is moved to the cost of sales, which is an expense account. The goal as a business owner is to maximize the amount of inventory sold while minimizing the inventory that is kept on hand. As an example, if the cost of sales for the month totals $400,000 and you carry $100,000 in inventory, the turnover rate is four, which indicates that a company sells its entire inventory four times every year.

The inventory turnover, also known as sales turnover, helps investors determine the level of risk that they will face if providing operating capital to a company. For example, a company with a $5 million inventory that takes seven months to sell will be considered less profitable than a company with a $2 million inventory that is sold within two months.

 

The reciprocal of the inventory turnover ratio (1/inventory turnover) is the days sales of inventory (DSI). This tells you how many days it takes, on average, to completely sell and replace a company’s inventory.

What Is Portfolio Turnover?

Turnover is a term that is also used for investments. Assume that a mutual fund has $100 million in assets under management, and the portfolio manager sells $20 million in securities during the year. The rate of turnover is $20 million divided by $100 million, or 20%. A 20% portfolio turnover ratio could be interpreted to mean that the value of the trades represented one-fifth of the assets in the fund.

Portfolios that are actively managed should have a higher rate of turnover, while a passively managed portfolio may have fewer trades during the year. The actively managed portfolio should generate more trading costs, which reduces the rate of return on the portfolio. Investment funds with excessive turnover are often considered to be low quality.

Why can mutual funds with high turnover rates be detrimental?

Funds with high turnover ratios might incur greater transaction costs (such as trading fees and commissions) and generate short-term capital gains, which are taxable at an investor’s ordinary income rate.1

What is asset turnover?

The asset turnover ratio is a measure of how well a company generates revenue from its assets during the year.

$\begin{aligned} &\text{Asset Turnover} = \frac{ \text{Total Sales} }{ \frac { \text{Beginning Assets}\ +\ \text{Ending Assets} }{ 2 } } \\ &\textbf{where:}\\ &\text{Total Sales} = \text{Annual sales total} \\ &\text{Beginning Assets} = \text{Assets at start of year} \\ &\text{Ending Assets} = \text{Assets at end of year} \\ \end{aligned}$

Investors use the asset turnover ratio to compare similar companies in the same sector or group.

What is working capital turnover?

Working capital turnover measures how effective a business is at generating sales for every dollar of working capital put to use. Working capital represents the difference between a company’s current assets and current liabilities.

What is an example of turnover?

Consider the following inventory turnover example: A company has $100,000 in sales in one month and average inventory of $10,000. The $100,000 in sales is divided by the average inventory of $10,000 to arrive at a turnover of 10. Here, the company turns over its inventory 10 times per month.

What is the difference between turnover and profit?

Profit refers to a company’s total revenues minus its expenses. By contrast, turnover can refer to how quickly a company either has sold its inventory or is collecting payments compared with sales over a specific time period. Generally speaking, turnover looks at the speed and efficiency of a company’s operations.