Equity Turnover RatioDefined along with Formula & How to Calculate

Written By:
Lisa Borga

The equity turnover ratio measures the proportion of the sales a company has to its shareholders’ equity.

This is used by companies to help them determine whether or not they are generating enough revenue for shareholders to want to hold their stock.

This ratio is considered very important for companies as it allows them to see the amount of revenue that can be generated by shareholders’ equity in a year’s time.

Investors sometimes calculate this ratio before investing in a company because it allows them to see how their investment would affect the company.

Equity Turnover Formula

Equity Turnover Formula = Net Sales / Average Shareholders’ Equity

Net sales in this formula can be obtained by subtracting any sales returns or sales discounts from gross sales.

Average shareholders’ equity can be calculated by adding the shareholders’ equity at the start of the year to the shareholders’ equity at the end of the year and then dividing this figure by two.

Understanding The Equity Turnover Ratio

It’s not always easy to understand the equity turnover ratio.

However, typically, an increasing proportion is considered good, whereas a decreasing proportion is considered bad.

However, there are a few things that should be considered.

Here are some of them.

• The equity turnover ratio varies considerably based on how capital intensive the industry is. As an example, the equity turnover ratio for the fast-food industry would be much higher than that of the auto manufacturing industry. Therefore, it is important when comparing the ratios of different companies to ensure that they are in the same industry.
• If a company decides it wants to increase its equity turnover ratio to try and obtain more shareholders, it could affect the company’s equity by increasing its debt percentage in the capital structure. Doing this can be quite risky for a company because they can take on a lot of debt that will have to be paid back with interest.

Example of Equity Turnover Ratio

Here is how to compute the equity turnover ratio for each of these companies.

Below are the gross sales and the discount on sales for these businesses.

Next, the average equity will need to be calculated for each company.

Next, we will compute the equity turnover ratio for each company.

The equity turnover ratio for these companies can be compared if they are in the same industry.

Company X has a higher equity turnover ratio than Company Y.

However, this doesn’t necessarily indicate that Company X is doing better overall than Company Y.

But, it does mean that Company X is doing a better job of generating income from equity than Company Y.

Target Example

We will check the income statements and balance sheets for Target for 2020 and 2021 and compute the company’s equity turnover ratio.

Target’s equity turnover ratio remained steady from 2020 to 2021.

Both their sales and their total equity increased over this period.

They made approximately $1.83 for every dollar of shareholders’ equity.

Ford Motor Company

Ford Motor Company’s equity turnover ratio decreased over this period of time.

The company’s sales increased over the period, but its equity increased more, which caused a decrease in the ratio.

Planet Fitness Example

Planet Fitness has a negative equity turnover ratio.

This happens when shareholders’ equity is negative.

If shareholders’ equity is negative, the company’s liabilities are greater than its assets.

Therefore, there is no equity from which income can be generated.

Limitations of the Equity Turnover Ratio

A company’s equity turnover ratio is useful for an investor to look at before investing in a company.

However, it does have limits that should be considered when using the ratio.

Here are a few limits.

• Equity doesn’t always produce revenue.
• The equity turnover ratio is not useful for companies that generally obtain capital through debt.
• Companies can manipulate the equity turnover ratio in order to attract investors by altering their capital structure.

The equity turnover ratio is useful for investors or companies that generally use equity options for capital.

However, for other companies and investors, there are ratios that are better than the equity turnover ratio.

This ratio, along with the cash ratio, is not used very often.

But, for those who want to compare net sales to total equity, it can provide this information.