What is Turnover
Turnover is an accounting term that calculates how quickly a business collects cash from accounts receivable or how fast the company sells its inventory.
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.
BREAKING DOWN 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.
How Accounts Receivable Turnover Is Calculated
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, as compared to your credit sales. If credit sales for the month total $300,000 and the account receivable balance is $50,000, for example, the turnover rate is six. The goal is to maximize sales, minimize the receivable balance, and generate a large turnover rate.
Factoring in Inventory Turnover
The inventory turnover formula, which is stated as 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 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 4. A turnover ratio of 4 indicates that a company sells its entire inventory four times every year.
The inventory turnover, also known as sales turnover, helps an investor determine the level of risk s/he will be faced with 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.
Examples of 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% turnover ratio could be interpreted to mean 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.