Understanding company fundamentals – Turnover

Turnover is a financial term which refers to how much cash has entered a company’s bank account in a given period. In most companies, it reflects the value of its sales in that year, either of goods or services, but before costs such as salaries and taxes. Most investors like to see an increasing turnover in their investments, as they believe more money coming in through the door means more profits, and thus a healthy and successful company. But is this true?

Consider the following examples;

  • A pipe manufacturing company has grown their turnover by 20% a year for five years and looks like a fantastic opportunity. They’re a recognised brand name and have been in business for decades. You decide to invest. Unfortunately, costs are increasing at 21% a year, and profitability is only 2%. As a result, in two years the company will be losing money and only has cash reserves to last another five unless this changes. Not a great investment after all…
  • A car dealership has had turnover spike to a ten-year high. Investors are piling in, thinking that the market loves the company’s product and service, but in truth, the company has just sold off their entire stock at a massive discount, liquidated their property portfolio, and sold a parcel of land they’d had on the books.The next year, none of these strategies can be repeated, causing turnover to collapse to a new low and the share price with it. Another poor investment.
  • You’ve seen an opportunity to invest in a leading supplier of building materials in the construction industry. The family-run business has doubled its turnover every two years for the last decade and is regularly cited in industry periodicals as being an exemplary company. Unfortunately, the value of its accounts receivable has also been increasing each year, but the company has been including these at face value within the overall sales figure. The growing accounts receivable fund continues to spiral until the next recession, when 80% of it is written off as bad debt. The debt-to-equity ratio suddenly spikes, causing lenders to pull funding as the company breaches its banking covenants and the lack of working capital causes a severe cash flow crisis for the company which has to pull out of several major supply contracts. The share price collapses.

Although extreme, the increase in turnover in these examples is less of an indication of flourishing health and more of a cover for a potential bankruptcy. Turnover needs to be considered as part of a wider trend in a company’s financial performance, as well as being contextualised with other factors such as their profitability, leverage, debt-to-equity ratio, and overall market conditions.

In the next article of the Understanding Company Fundamentals series, I’ll be looking at profitability, which sits at the other end of the income statement, and is an important part of contextualising turnover.