The investment turnover ratio compares the revenues produced by a business to its debt and equity. The ratio is used to evaluate the ability of a management team to generate revenue with a specific amount of funding. The “turnover” part of the term indicates the number of multiples of revenue that can be generated with the current funding level.
The formula for the investment turnover ratio is to divide net sales by all stockholders’ equity and outstanding debt. The calculation is:
For example, a business has $2,000,000 of net sales, $700,000 of shareholders’ equity, and $300,000 of long-term debt. Its investment turnover ratio is 2:1.
There are several issues with this ratio to be aware of, which are:
- Not related to profit. The ability to generate sales volume does not mean that a company also generates a profit. Thus, there may be an outstanding investment turnover ratio that is coupled with ongoing losses.
- May not extrapolate. A business may have an excellent historical turnover ratio, but the addition of more funds may not produce the same turnover rate. This occurs when the original market niche has been maximized, and additional funding must be redirected into a less-familiar market segment.
- Not comparable. This ratio cannot be used to compare businesses located in different industries. One industry may require a hefty fixed asset base and so requires a large investment, while another industry may require no fixed assets at all, so fewer funds are needed to produce the same amount of sales.