Equity turnover is the measurement of a company’s net sale over the company’s average equity. It tells how efficiently the company uses shareholder’s equity to generate sale to grow the company. Shareholders want to access if they are worth holding the company shares or let them go.
Higher rates mean managements have efficiently used funds and be able to make more sales compared to other companies. It represents the amount of return from each dollar of shareholders’ equity.
Equity Turnover is very useful for both existing and new shareholders who are interesting to invest in the company as show how well the company performs by using shareholder fund to generate a sale for a profit.
A company equity raise is an opportunity for the owner or investor to increase their stake in the company. This can be done through a variety of methods, including issuing new shares, selling shares to existing shareholders, or selling shares to new investors.
When investing in a company, shareholders typically have one primary objective: to make money. There are a number of ways to make money from owning shares in a company, including dividends, share price appreciation, and selling the shares for more than they were purchased for. While there is no guarantee that any investment will make money, shareholders usually seek out companies that have a history of financial stability and strong growth prospects. By investing in these types of companies, shareholders hope to generate a return on their investment that outperforms the overall market.
Equity turnover is one of the ratios that investors can use to evaluate the company’s performance before making an investment decision.
Equity Turnover Formula
We can calculate the equity turnover by dividing the annual sale by average equity. It measures the company’s ability to generate sales from the capital invested by the owners/shareholders.
|Equity Turnover Ratio = Annual Net Sale / Average Shareholders’ Equity
- Annual net sale: is the amount of sales during the year excluding sale allowance, sale return, and discount.
- Average shareholders’ equity: is the amount of equity on the balance sheet between two years and divided by two.
Equity turnover Example
Based on Company A’s current financial statement, they have made an annual sale of $ 500,000 and their equity for the prior year and current is 100,000 and 120,0000 respectively. Please calculate the equity turnover ratio.
Equity Turnover ratio = Annual Net sale / Average Shareholders’ Equity
= 500,000 / [100,000+120,000)/2] = 4.34 times
It means that the company generates $ 4.34 from one dollar of shareholders equity.
Problems with Equity Turnover
Company Capital Structure
It is hard to access company performance by relying on this ratio as it may be different from one company to another. Some companies may use debt rather than equity, so it will show a huge equity turnover ratio which does not represent the real situation.
Company Equity Size
Different industries may require different levels of equity investment. A small business such as a coffee shop and restaurant may not require a huge amount of capital. On the other hand, the oil and refining business will require a large amount of capital before generating a significant amount of sales. So if we compare both companies, there will be a large variance which cannot tell the whole story.
No Clear Rank
Based on the ratio we cannot decide whether it is good or bad, we can only compare it with other companies. Even though, it is still not clear if they are the most appropriate as they are different in size and industry.
The management can manipulate the ratio by using debt rather than equity. When the company uses debt more than equity, the ratio will skyrocket. However, using too high debt will make a negative impact in the future.
Advantages of Equity Turnover
- Access company performance: When trying to access how well a company is performing, there are many ratios an investor can look at. Each ratio provides different information and gives different insights into how the company is doing. Equity turnover is one of the tools that investors can use to evaluate a company. It tells the best estimation of the return that the company generates from the equity investment.
- To compare between companies: Due to the simplicity of the calculation, the investors can compare the ratio across a wide range of companies to select the best one.
Disadvantages of Equity Turnover
- Subject to manipulation: The calculation is based on the figure from the financial statement which can be manipulated by the management. They can boost the sale at year-end and return back the next year to make the ratio look good.
- Not comparable: It is hard to make an analysis of the result from one company to another as they make have different capital structures. Some companies rely heavily on debt rather than equity, while others tend to use equity more. So it is not a good idea to compare the equity turnover between these companies.
- Not suitable for a startup: The startup mostly has not yet generated many sales, so it is hard to access its performance.