Savvy investors employ any tools available that will give them an edge, including those that can analyze businesses before they invest their capital. One important tool is turnover ratio, which is important because it indicates how frequently goods are sold.
With that said, here is what investors need to know about understanding turnover ratio: a key metric for assessing business efficiency. Depending on the type, turnover ratio can also gauge employee turnover, help with mutual fund decisions, and more.
In business, there are times when a product can barely be kept in stock, such is its popularity. Then there are other situations in which deep discounts are called for to spur sales.
Usually, though, items are somewhere in the middle: they float along, neither “hot” nor a drag on the bottom line.
Enter turnover ratio — also called turnover rate — which is a way to gain a good idea of what is moving product-wise, and how swiftly. Such a calculation can inform everything from supplier relationships and product lifecycles to promotions and pricing strategy.
Such a tool can also tell quite a bit about how adept a company is at inventory management, forecasting, and sales and marketing. For example, a high ratio suggests robust sales, or it can imply insufficient inventory to handle sales at that rate.
Whatever the case may be, understanding the sales picture can help a company know how to set its direction and can help investors decide where to put their capital.
In investing, a turnover ratio is the percentage of a portfolio’s holdings, or of a mutual fund, that have been replaced over the course of a year.
There are funds that maintain their equity positions for less than a year, which means their turnover ratios surpass 100 percent. Note that this does not necessarily mean that all investments have been replaced. What the ratio does is indicate the proportion of stocks that have changed in a single year.
The turnover ratio can vary depending upon the mutual fund type, its investment goal, and the portfolio manager’s investing approach.
To illustrate, because it duplicates a certain index and supplants holdings only upon index changes, a stock market index fund will generally have a depressed turnover rate. On the other hand, a mutual fund that is actively traded could have a loftier turnover rate, contingent upon how assertive the fund manager is in terms of buying and selling holdings in the hunt for improved returns.
Actively managed funds that have a low turnover ratio indicate a buy-and-hold investment approach. By contrast, funds that have relatively high turnover ratios signify a market-timing strategy.
This largely depends on the turnover ratio type, which is elaborated on below. In a company, for instance, the ratio is the percentage of employees who leave within 12 months. Thus, a low ratio means that individuals seldom leave the organization. A high ratio indicates the opposite.
It may seem as if, here, a low ratio is the goal. However, that is not necessarily the case, as there is no optimal turnover rate. By their very nature, some industries have relatively high turnover rates. Information technology is an example because that field’s employees are always in high demand. On the other hand, turnover ratios are high in retail and hospitality because those jobs are generally hard and underpaid.
As a measure of efficiency, turnover ratio in business is the time it takes the company to sell the goods for which money was spent up front to acquire. The calculation, which can be applied to inventory or any other business cost, calls for dividing annual income by annual liability.
Note that in business – unlike in investing – a high turnover ratio is typically a positive sign. For example, the ratio could show that the company’s goods are selling out as fast as it comes in.
If the calculation is for the mutual fund space, the ratio is the percentage of the fund’s holdings that have been supplanted over the course of 12 months. The ratio is typically listed in the company’s mutual fund prospectus. Note that, to work the formula out, the investor would have to know the sales price of each transaction that occurred during the year as well as the average monthly net value.
The formula is thus:
Either the total dollar value of all new portfolio assets, or, the value of assets sold, if that is a smaller total, divided by the monthly average net fund assets, times 100.
There are various types of turnover ratios, including:
To calculate the asset turnover ratio, the first step is to determine sales, followed by calculating the average total assets through this formula:
Average total assets = opening total assets + closing total assets /2
Then, calculate the asset turnover ratio:
Asset turnover ratio = sales / average total assets
To calculate this ratio, first get total credit sales, which are customer purchases for which payment is given on a future date, and so is delayed. Then, the average accounts receivable is computed using this formula:
Average accounts receivable = opening accounts receivable + closing accounts receivable /2
After that, calculate the receivables turnover ratio calculation thusly:
Receivables turnover ratio = credit sales / average accounts receivable
This gauges how many employees over a given period, typically a year, leave a company. The rate is calculated by dividing the number of employees who left by the average number of employees, then dividing that figure by 100. The rate helps to measure the company’s retention and how effective its human resources management system is, as well as its management overall.
Monthly turnover percentage = Employees separated
——————————- x 100.
Average number of employees
Note that dismissals, voluntary resignations, retirements, and non-certifications are typically included in turnover calculations. However, such calculations typically do not include in-house actions such as transfers or promotions.
Here is an example of asset turnover ratio. Consider the retail business company Dynamic Firms, which recorded:
The first step here is to calculate the average total assets:
Average total assets = (total assets for 2021 + total assets for 2022) /2
= ($20,000 + 30,000) /2 =$25,000
Then, the asset turnover ratio must be calculated:
Asset turnover ratio = Net sales / average total assets
= $100,000/$25,000 = 4
In terms of interpretation, the asset turnover ratio of 4 means that each dollar Dynamic has put in assets generates $4 in sales. Note that the asset turnover benchmark in the retail industry is 2.5. Therefore, Dynamic’s asset ratio turnover exceeds the industry average and indicates that the company manages its assets efficiently.
By itself, a turnover ratio has no inherent value. For example, a high turnover ratio is not automatically negative, just as a low turnover ratio is not necessarily good. However, investors should understand the fallout of turnover frequency.
High turnover frequently causes heightened fund costs due to spread payments and commissions when purchasing and selling stocks. Such increased costs ultimately are passed on to investors and show up in the fund’s return.
Further, the frequency of a fund’s portfolio turnover, the more likely it is that the fund will produce short-term capital gains – profits on assets held for under a year and which are taxable at an investor’s ordinary-income rate. Such a rate is frequently higher than the capital gains rate.
It also can be helpful to chart how the ratio is trending to determine whether the fund manager’s investment approach has changed. Say that over a three-year period a portfolio’s turnover ratio has changed from 20 percent to 80 percent. This would indicate that the fund manager has markedly changed their investment approach.
In short, funds with a high turnover rate generally indicates a fast-paced investment approach – a considerable amount of securities buying and selling. These funds are “actively managed.”
On the other hand, a low turnover ratio – typically 30 percent or lower – indicates a buy-and-hold investment approach. Such funds are referred to as passively managed funds.
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Turnover ratio is a key metric for investors since it gauges the value of a company’s revenues or sales relative to its assets’ value and reflects how efficiently the organization employs its assets to generate revenue. It also can help investors establish whether a mutual fund is right for them. If when conducting research an investor finds that other funds have lower or higher funds than sought, for example, that may be an indication that the fund’s performance should be more closely examined.
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