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

What Is Turnover?

Turnover is how quickly a company has replaced assets within a specific period. It can include selling inventory, collecting receivables, or replacing employees. It can also represent the percentage of an investment portfolio that is replaced.

Turnover might also mean something different depending on the area you're in. For instance, overall turnover is a common synonym for a company's total revenues in Europe and Asia.

Understanding Turnover

Turnover ratios calculate how quickly a business conducts operations. This measures efficiency and how well it is using its resources.

Two of the largest assets owned by a business are usually accounts receivable and inventory, if any is kept. Both of these accounts require a significant cash investment, and it is important to measure how quickly a business collects cash. Turnover ratios are used by fundamental analysts and investors to assist them in determining if a company is managing its finances and assets correctly.

Common types of turnover ratios include:

• Accounts receivable turnover
• Inventory turnover
• Portfolio turnover
• Working capital turnover

Companies can better assess the efficiency of their operations by looking at a range of these ratios. Good turnover ratios can be high, mid-range, or low, depending on what a company is measuring. For instance, a low accounts receivable turnover ratio means a company's collection procedures or credit-issuing policies might need to be fixed. However, the same company might be a retailer with a high inventory turnover ratio, which can indicate strong sales.

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 period, such as a month or year.

The accounts receivable turnover formula tells you how quickly you collect payments compared to 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.

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. For example, if the cost of sales for the month totals $400,000 and you carry $100,000 in inventory, your turnover rate is four, which indicates that you sold your entire inventory four times that month.

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. Retailers tend to have the highest inventory turnover. The speed can be a factor of the industry in general or indicate a well-run company.

What Is Portfolio Turnover?

Turnover is a term that is also used for investments. In this context, turnover measures the percentage of an investment portfolio that is sold in a set period.

For instance, assume 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. However, it might also indicate a need to investigate further and determine why the mutual fund needed to replace 20% of its holdings in one year. In some cases, the fund's manager might be "churning" the portfolio, or replacing holdings to generate commissions.

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 will 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.

Asset Turnover

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

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

You can also use just the assets at the end of the period instead of the average for the year to calculate the ratio. Investors use this ratio to compare similar companies in the same sector or group.

The Bottom Line

Turnover can be either an accounting concept or an investing concept. In accounting, it measures how quickly a business conducts its operations. In investing, turnover looks at what percentage of a portfolio is sold in a set period.

A business will have many types of turnover to measure, but the most common are inventory and accounts receivable. Accounts receivable turnover shows how quickly a business collects payments. Inventory turnover shows how fast a company sells its entire inventory. Investors can look at both types of turnover to assess how efficiently a company works.