Nominal and Real Value of Money
The previous article was an introduction about the two basic decisions that corporate finance helps a corporation in making. Prima-facie, these two decisions may look pretty simple. After all everyone raises money in their daily lives and puts it to productive use. Simple accounting can tell us whether or not we should make those financing […]
The Anatomy of Commodity Indices
Movements in the stock markets are easy to track. This is because instead of looking at the movements in the price of several different stocks, investors can simply look at the movement in the underlying index. This is where the concept of index is derived from. It provides a pulse of the market wherein one […]
Over the Counter Markets
Over the counter markets are a particular type of financial market. Generally, financial markets are centralized. This means that there is one central body that is a counterparty to all the trades being made. For instance, if A wants to trade with B, the transaction does not happen directly. Instead, A trades with the centralized […]
Building a Startup Team
When people think about how startup founders invest their time, most of them think about dealing with investors or managing the operations of the firm. Almost, no one imagines that the founder of a startup company spends a considerable amount of their time in building a team. This is because hiring is not considered to […]
Two Fundamental Rules of Corporate Finance
Corporate finance is based on two fundamental rules. All tools and techniques of corporate finance are mere ways and means of implementing these rules. These rules can be found at the beginning of any and every corporate finance text book. One of these rules relates to the concept of return while the other relates to […]
Turnover ratios (also known as efficiency ratios) are a very important class of ratios. These ratios are not only used by financial personnel but also by the people in charge of operations. However, we are going to consider these ratios from the point of view of outside investors. This is because judgments have to be made about the efficiency of the firm based on limited information at hand. Here is an elementary introduction to what turnover ratios are and why they are important.
Over the years, investors have realized one rule and that is “Efficiency means growing business”. Any firm which is more efficient than its peers in producing the same goods and services will be more profitable in the short run. This profitability will allow the firm to build a competitive moat around itself and these businesses often become very valuable. This is like an investors dream formula for success. It is for this reason that investors carefully look at the efficiency numbers of newbie firms.
Finding out whether the firm is efficient is difficult even for a manager or an employee who has all the information at hand. Investors on the other hand just have the financial statements. They have to use these financial statements as their window into the operations of the firm. This is possible because every activity done by the firm involves costs and therefore leaves a trail on the financial statements. The turnover ratios are the investors’ method to connect the dots. They use information which is available in different financial statements. They then aggregate this information together and make meaningful conclusions about the operations of the company.
Turnover ratios as the name suggest, are related to sales. The logic is that given a certain amount of assets, how much sales can a company achieve? Therefore turnover ratios are always a comparison between an income statement item i.e. sales and the corresponding balance sheet item. For example if we compare fixed assets to sales, we get fixed asset turnover ratio. On the other hand when we compare accounts receivable to sales we get accounts receivable turnover ratio.
In case of inventory turnover ratio we use the COGS figure listed on the income statement rather than the sales figure. This is because inventory is reported at the cost price.
In conclusion, turnover ratios provide early clues to the efficiency of a firm. This can go a long way in making a successful investment and therefore an investor must learn how to use these ratios to his/her advantage.
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