- Date : 23/04/2021
- Read: 5 mins
What are turnover ratios and how do they reflect the state of finances of a company and influence stock growth?
A ratio is a mathematical relationship between two amounts. And ratio analysis is an important part of financial reporting. In business, a comparison of annual turnover figures in the form of ratios can indicate a company’s business performance. But such ratios aren’t something that financial managers simply present to the board of directors. They are popular reference points for investors, who keep an eye on key business ratios to judge a company’s performance.
What are turnover ratios?
As the name suggests, a turnover ratio is a comparison of key financial numbers with the turnover of the company. These numbers include the assets and liabilities of the company, while the ratio indicates how quickly (or slowly) the company replaces them with respect to its sales. These ratios reveal the company’s efficiency in generating return on investment and cash management. As an investor, you can refer to them while deciding your position on a particular stock. But before you start making investment decisions, there are some important turnover ratios you need to consider.
- Accounts receivable: Also known as the debtor turnover ratio, this ratio indicates how soon a company collects money for the sales made on credit. A higher account receivable turnover ratio indicates the number of times the company collects its receivables over a sales period. This is impacted by the company’s credit period, payment terms, promptness of billing and recovery, etc. It is calculated by comparing credit sales and average receivables.
- Inventory: This ratio reflects how quickly a company converts its inventory to sales. It is calculated by comparing the cost of goods sold and the average inventory. The ideal inventory ratio can vary from industry to industry. So, it will have to be compared with industry standards, the company’s targeted ratio, and previous performances.
- Fixed assets: Fixed asset dependant companies such as heavy manufacturing concerns use fixed asset turnover ratio to gauge how well their fixed assets are being used. A company with a healthy fixed asset turnover ratio would post high turnover with limited fixed assets at their disposal. Total asset turnover ratio is a variation of this, and compares total asset with total sales.
- Accounts payable: A reverse of the accounts receivable ratio, a low accounts payable ratio indicates that the company can hold creditor payments for a longer period. It indicates that the company can hold on to cash for a longer time.
- Capital employed: By measuring this, you can find out how well a company is doing in terms of sales for a given amount of capital employed. If the company is garnering decent revenue on a limited capital outlay, it also indicates room for additional investment and scope for future growth. Apart from this, other turnover-driven ratios like return on equity (average income/average stockholder equity) and price-to-sales ratio (price per share/annual sales per share) are useful for investors.
Related: How to choose an equity mutual fund
Turnover ratio and stock performance
Healthy turnover ratios are good indicators of an efficiently run company. You can easily find out the turnover ratios of your shortlisted companies and compare them with industry and peer performances. Let us look at some examples.
The fixed asset turnover ratio of Radico Khaitan showed a steady increase in 2016-2020, rising from 0.98 to 1.36. During this period, its earning per share increased more than three times, whereas dividend and operating profit per share increased by around two times. Consequently, the increased turnover ratios is reflected in the company’s growth. Dealing in liquor and fertiliser, Radico Khaitan has excellent scope for price and growth increase, making it a promising investment option.
Do remember that looking at ratios is not enough to base your investment decision. Take Hindustan Unilever, for instance. Its inventory turnover ratio has fallen gradually in the last five years (ending March 2020) from 13.25 to 4.83. The fixed assets ratio too fell during this period, from 6.21 to 4.94. We can expect that an established FMCG major would be robust enough to cope with lower turnover ratios. Nevertheless, rising turnover ratios are an important characteristic of a growing company.
Conversely, a stock on a downhill ride would be unfit for investment even if it manages to keep its ratio healthy. For instance, if a company’s sales and production reduce by half, a good turnover ratio can still be maintained, but only in a mathematical sense. Falling turnover ratios coincide with falling stocks in most cases of business contraction. Take the case of PC Jeweller’s stocks in recent years. The company’s reported EPS fell from Rs 22 to Rs 2 between 2016 and 2020, and the operating profit reduced to a quarter. Its fixed asset ratio and inventory ratio also fell by 2.5 and two times respectively.
There are numerous examples in the stock market where rising turnover ratios have been followed by company growth and higher profit on investment. Of course, the scale of operations is an important factor when comparing ratios across companies and industries. Large corporations can maintain healthy financials despite a slowdown in their turnover ratios. Besides, the applicability of certain ratios in different industries would also vary. Fixed asset ratio would have limited influence on a service provider’s stock, but its accounts receivable ratio would be vital.
If you spot a company with impressive turnover ratios, it would mean the company is generating more sales with limited capital and fixed assets. It can rotate more stocks, as its higher inventory turnover ratio would indicate. Such parameters are important for a company to run its operations successfully. So, consistently healthy and rising turnover ratios are an encouraging indicator. Investment in such companies is more likely to be a safe bet as they are more scalable and better prepared to handle temporary blips in their finances. Lastly, look at these 6 Common stock trading mistakes you should avoid.