Activity Ratios: Turnover Ratios
Working capital is kind of a waste.
Precisely.
A lower asset balance means a higher ratio, and _artificially_ higher to a degree. So while these turnover ratios are good measures of efficiency, showing how efficiently a firm uses assets to create revenues, there are always things to look out for, and potential distortions to adjust away.
An analyst that ignores things like this could be part of turnover as well.
To summarize:
[[summary]]
No, they would be higher.
Recall that working capital is current assets minus current liabilities. Companies need to have this positive difference to stay liquid enough for operations. Cash, accounts receivable, and other very short-term assets have to "cover" those short-term liabilities like accounts payable. Some leftover is safe. Still, these aren't assets that are being used most productively. So what might be a good "more is better" measure of how productive the company is with that working capital?
No.
Just looking at current assets ignores current liabilities. Use working capital instead.
No.
This would be a "less is better" measure.
That's right!
This is called __working capital turnover__, and it's one of several "turnover" ratios that are all revenue divided by something. The idea is "how much revenue is earned per unit?" in each case.
Also, in each case, the denominator is a balance sheet item, just like here. What do you think that means for each calculation?
No.
Revenue must _not_ be an average, actually. It should just be the total for the period of interest.
Yes.
Revenue covers a period, such as a year. If that's what you're using, then the denominators must be an average of at least the beginning of year and end of year balances.
No, they aren't.
That would distort the ratios.
Aside from "turning over" working capital to create revenues, you might also want to see how well a company turns over its fixed assets, like land, buildings, and equipment. This is the __fixed asset turnover__ ratio, and it's revenue divided by average fixed assets. There's also __total asset turnover__, where you'd just use total assets instead of fixed assets. Which ratio do you think would be larger?
No, fixed asset turnover will be larger.
You got it!
Suppose two companies are identical in nearly every way, but these two turnover ratios are different. What might be a reason?
Not really.
Ratios eliminate those differences.
Exactly.
Many leases are "capitalized" on the balance sheet, but you can't be sure. Differences like this can cause differences in the ratio that are just distortions. Another is the age of the assets. If one company has older assets, they will be more depreciated, and therefore have a lower book value. What effect would that have on these ratios?
No.
This wouldn't affect these turnover ratios at all.
Total assets are larger than just fixed assets, so that larger denominator will produce a smaller ratio.
Revenue divided by current assets
Working capital divided by revenue
Revenue divided by working capital
Revenue must be an average
The denominators must be an average
The end of period balances are most appropriate
Total asset turnover
Fixed asset turnover
One company is twice the size of the other
One company rents equipment while the other owns it
One company sells for cash while the other sells on credit
The ratios would be lower
The ratios would be higher
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