What is Capital Turnover Ratio?

Definition: This refers to level of contribution made by capital employed towards sales or turnover generation. Capital employed is the determining factor such that if it is effective in its functionality, then a small change in capital employed will result to relatively more change in the sales level of the firm (holding other factors such as selling price constant). In other words, this proportion displays the proficiency of capital employed in the business

Demonstration

Where;

(a)Capital employed is the sum of owners capital/equity + non-current liabilities (note, this is what is referred to as Gross capital employed)

OR

(b)Capital employed?=Total assets−Current liabilities (note, this is what is referred to as Net capital employed)

OR

(c) Net Asset=Capital Employed

     Net Asset=Total Assets-Current Liabilities

Net Sales=total sales-Returns Inwards

NB1: The higher the ratio the greater are the profits and the vice versa is true

NB2 : When we talk of capital employed, we refer to Net Asset=Capital Employed and this is what is always used in the capital turnover ratio.

Example

Given the following balance sheet information of Mosmos co ltd for the year ended 31st/03/2016, compute the capital turnover ratio and comment on the efficiency of the capital employed

Additional information

Net sales for the year ended 31st/03/2016 was $420,000

Solution

Interpretation/comment

For every 1.00$ invested in capital, it generates $0.63 of sales of the business   contribution made by capital employed to Sales;

Applicability of Capital Turnover Ratio in Decision Making by Management

Capital Turnover Ratio is expressed as Net Sales/Capital Employed  where by the net sales represents the numerator factor (dependent variable) and the capital employed represents the denominator factor (independent variable, or the determinant) and the management can anchor its decision making process to improve efficiency as follows;

Denominator factor; Capital employed the investment made in total net assets of the business which is sum of all non-current assets plus net current assets. This factor is controllable by the management for its acquisition decision is in the hands of the management such that;

The management need to identify the cheapest and most efficient assets, although the reality on the ground is that the more efficient an asset is the more costly it is. However, the management has to balance the cost of acquisition of the asset resources with the right quality.

If the right asset resources are acquired by the management, this will positively contribute to increased efficiency which in turn will increase the sales value of the business. otherwise a wrong choice of asset resources will lead to a decline in capital turnover ratio.

Numerator factor; Net sales is the expected output and its value can partially be controlled by the denominator (i.e capital employed) or other internal and external factors. For the external factors, we hold it constant for the management cannot control it. A good example of the external factors is the market price of the goods sold for this is determined by the forces of demand and supply. Also, the level of competition is another example of external factor which the management can not control.

So the management should focus of the controllable factors represented by the denominator such as the quality of capital employed and its pricing.