Cash Turnover Ratio
Cash turnover ratio is the ratio that measures the number of times that a company uses its cash to generate sales. It is the comparison between cash on hand and the annual sale.
It helps to estimate the required cash or cash equivalent needed to achieve the target sale. Cash is one of the current assets which is very important for the business. Company uses cash to pay for suppliers, employees, tax authorities, and so on. Cash is very important and company needs it everywhere, but its balance is limited. So management is looking for a way to minimize the cash required to run the business. Keeping cash on balance sheet without investing is not a good idea, we will lose the opportunity to make more returns. If keeping too little cash, it is also not good as company can be liquidated due to lacking cash to settle the obligation.
Sale is very important for business, without sale we will not able to generate profit. It is the company’s objective to sell goods or services to customers. The revenue will generate profit after deducting the cost of goods sold and expenses. So every company works very hard to increase sales and profit.
As a result, the company figures out the efficiency of cash turnover ratio by reducing the cash balance without impacting the sale balance. It means we try to maximize the result from the cash available.
It is the number of times in which the cash is used within one accounting period. We can measure it by comparing sales over the average cash balance.
We can compare the cash turnover for the company in the same industry to find out if they are efficiently using the available cash to generate revenue.
Cash Turnover Ratio Formula
Cash Turnover Ratio = Annual Sale / Average Cash Balance
Average Cash Balance = (Beginning Cash balance + Ending Cash balance)/2
Cash Turnover Ratio Example
For example, Company A made $ 800,000 in sales last year. The cash balance at the end of year 1 and year 2 is 20,000 and 30,000. Please calculate the cash turnover ratio
Cash Turnover Ratio = 800,000 / [(20,000+30,000)/2] = 32 times
It means that the company can generate sales 32 times their cash balance. It shows how efficiently they use the cash to make sales. If it is too low, it means the company does not use the cash effectively, they are underperforming. Usually, the more times company can use cash to generate sales is better because they can make more profit. On the other hand, if it is too high, the company may over-perform and lack of cash to support the operation.
If the company wishes to double the target sale, we need to increase the cash floating balance as well. For example, if the target sale is $ 1,600,000 the cash balance should be around $ 50,000.
Disadvantages of Cash Turnover Ratio
Not Suitable for Credit Sale
If most of the company sales are on credit, using cash turnover ratio will not reflect the real situation. The ratio will appear to be larger than it should be as the cash balance is lower. The cash balances remain in the receivable balance as most of the sales are on credit, company requires some time to collect them. It is mostly used for the company which uses cash sales.
High Cash Fluctuate
Cash balance at the end of the year may be a significant increase due to various reasons such as a future acquisition. On the other hand, their cash balance may be significant decrease due to dividends or buying back the share. In such a case, the ratio will not show the real figure. It will be misleading for investors who solely rely on this ratio.