Capital turnover ratio: A useful ratio to help spot companies that could be struggling

Julie Brownlee, Fsp Invest, 02 Jul. 2014

Tags: capital turnover, capital turnover ratio, what is capital turnover, roce, investing strategy, ratio, retailers,

Many companies invest a lot of money into their businesses in order to make them grow and generate profits. But how do you know if the money a company is churning into its business is paying off? A company can appear to be doing fine, but it’s just cutting costs. This is where the capital turnover ratio is helpful. Let’s take a closer look at how it works…

What is the capital turnover ratio?

The capital turnover ratio is another way at looking at return on capital employed (ROCE) .

You get a company’s ROCE by multiplying its operating margin, which is the percentage of its sales it converts to profits, by its capital turnover. Capital turnover is the sales generated from each R1 invested, Phil Oakley in Money Week explains.

In other words…

Operating profit/sales x sales/capital employed = operating profit/capital employed

If a company is showing an improvement in its ROCE, this can be because the company is becoming more efficient. In other words, it’s improving its operating margins.

If ROCE is improving over the years, along with a better operating margin, you want to look deeper. And this is where capital turnover comes in. It’s a useful way to show you companies that could be heading towards problems.

Capital turnover is handy to use for looking at retailers

Capital turnover is particularly good to use if a company is in the retail sectors. These are companies that invest a lot of money into new outlets or branches.

With these types of companies, they can make their profit margins still look good just by cutting costs. But if the new outlets aren’t generating enough money from their investments, you can see the sales aren’t large enough.

If a company’s profit margins start to tumble, its ROCE can take a heavy fall. And if you see that capital turnover ratio is starting to ebb, this can be an early sign of problems ahead and a sign that it’s time to sell your shares.

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When you invest, it’s worthwhile spending some time checking things like this before committing a cent.

So there you have it, why the capital turnover ratio is useful to help spot companies that could be struggling.

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