Cash turnover ratio definition
/What is the Cash Turnover Ratio?
The cash turnover ratio is used to determine the proportion of cash required to generate sales. The ratio is typically compared to the same result for other businesses in the same industry to estimate the efficiency with which an organization uses its available cash to conduct operations and generate sales.
How to Calculate the Cash Turnover Ratio
The formula for the cash turnover ratio is to divide an organization’s annual sales figure by its average cash balance. The average cash balance may be the ending cash balance, or an average of the ending balance for each day of the reporting period, or some variation on these concepts. The calculation is as follows:
Annual sales ÷ Average cash balance = Cash turnover ratio
Example of the Cash Turnover Ratio
A business generates $10,000,000 of sales in its most recent year. The average month-end cash balance of the firm was $1,000,000. This means the cash turnover ratio of the organization was 10x per year.
The cash turnover ratio can also be used to estimate the amount of cash that will be needed to fund a projected increase in future sales. Thus, to continue with the preceding example, if there is a budgeted increase of $1,000,000 in sales and the cash turnover ratio is 10x, that means the company will require an additional $100,000 of cash to fund the sales increase.
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Problems with the Cash Turnover Ratio
There are several issues to be aware of that can make this ratio less effective. They are noted below.
Cash Distributions
Some entities routinely eliminate excess balances by issuing dividends or buying back shares. If so, their cash turnover ratios will appear to be much higher than those of competing businesses whose managers prefer to retain excess cash within the organization.
Credit Sales
This measurement does not incorporate credit sales, which may comprise the bulk of all sales generated by many businesses. When credit sales are being generated, this necessarily delays the receipt of cash until after the credit period has expired. Consequently, it is best to limit the use of the cash turnover ratio to those organizations that deal solely or almost exclusively with cash sales.
Gross Margins
If a business is contemplating selling new goods or services that have lower gross margins than its existing product mix, this will require a higher proportion of cash to fund the additional sales. This is because the cost of goods sold will be higher than is currently the case.