This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
A closely related factor is the rapidity of turnover of working capital. Although the word "turnover" has come to be highly popular, there is a remarkable absence of clear-cut, authoritative definition. Observation of customary usage, however, makes it plain that its meaning in the minds of merchants and manufacturers is always the same. "Turnover" may be defined as the ratio of annual gross sales to average working assets. It is the figure, in other words, which shows how many times the amount invested in working assets has been traded in or "turned over" during a year. Note that the relation is between gross sales and working assets, not between gross sales and working capital. There would be some advantage in basing figures on the second relation, but it is not customary to do so and it seems advisable to fall into line with customary business practice.
We hear a great deal about turnover in trading operations, particularly in retail merchandising, and comparatively little about it in manufacturing operations. It is, to be sure, relatively of greater importance to the merchandiser than to the manufacturer, but it is by no means unimportant to the latter.
As has previously been remarked, almost all the assets of a trading concern are working assets; the only capital invested in fixed assets is that which is given up to office furniture, store equipment, and the like. Both the wholesaler and retailer customarily buy on fairly liberal terms of credit and endeavor to sell the merchandise and make collections before their bills for the merchandise fall due. If they could always be sure of accomplishing this result, there would be no necessity for their possessing working capital; but, as we shall see in the next section, there is a strong tendency in this country toward shortening the period during which merchandise bills run and there is also an ever-present uncertainty as to the retailer's ability to dispose of his products within any fixed period; consequently, for both these reasons, he is called upon to provide a certain amount of working capital and often a very large amount. The manufacturer's proportion of working capital to fixed capital is much smaller than the trader's proportion. Nevertheless, up to the extent of his investment in working capital, he is interested as well as the trader in turnover.
It is clear that the greater the turnover, the larger the volume of business that can be conducted with a given working capital. If a retail store, for instance, is handling a product for which there is a great demand and which can be sold almost as rapidly as it is stocked, the gross sales will be large and the investment in stock will be small. If sales, on the other hand, are irregular and slow, the amount of working capital invested in stock will necessarily be heavy.
This is the first element in determining the rapidity of turnover. A daily newspaper stand will necessarily have a very rapid turnover, for the capital invested, plus the dealer's profit, will be realized in cash, at least once a day, and in the larger cities three or more times a day. The turnover for the newsdealer, under the above definition, is 500 to 700 times per year. As soon as the newsdealer adds a stock of magazines and books, which sell more slowly, his turnover decreases. At the other end of the scale is a great jewelry store, such as Tiffany's, in which it is necessary to provide an immense stock of valuable goods from which the customer may choose, while at the same time the sales are comparatively irregular and infrequent. Evidently the turnover in a business of this kind must be small.
In addition to the timeliness of the merchandise that is carried for sale and the degree of standardization of the merchandise, which determines how much stock must be carried in order to give a satisfactory range of choice to the customer, another element that determines rapidity of turnover is the sales policy of the merchandising firm. If the sales efforts are strongly directed toward disposing of a given stock of goods quickly - if necessary, making a sacrifice in price or incurring an extraordinary selling expense in order to achieve this result - the rate of turnover will clearly be higher than in case there is no definite, clearly thought-out sales policy. Right here is the point at which the financing of great numbers of retail stores breaks down. If a proprietor fails to recognize the great importance of achieving volume of sales and rapidity of turnover, even though an incidental sacrifice of profits here and there may be involved, the result is that his shelves gradually become loaded with unsalable goods; his receipts are not sufficient to meet promptly all his obligations for merchandise; his bills accumulate and his credit declines; and eventually he finds himself - usually to his own surprise - in a receivership or in bankruptcy.
Precisely the same elements determine the rapidity of turnover in manufacturing concerns. The timeliness or immediate salability of the manufactured product determines whether he keeps his stock of raw materials, half-finished products, and finished products moving or whether it piles up on his hands. Second, by standardization of his product, accompanied by advertising which impresses the consumer with the superiority of the standardized product, the manufacturer may cut down the number of his styles or varieties that he turns out. The automobile manufacturers have learned that one or two styles of chassis, each with two or three styles of body, is an ample line for any one manufacturer. Those that have been most successful do not offer even this much of a choice. Thousands of manufacturers are still turning out a large variety of products to meet the tastes - often the whims - of customers, when it would be possible for them to standardize both the demand and their own output and thus increase to a wonderful extent the turnover of their working assets. The third element - definite sales policy which endeavors to "clean up" accumulating stock - is almost as essential to the successful manufacturer as to the merchandiser.
In determining the rapidity of turnover the manufacturer is more or less circumscribed by one element that does not affect the merchandiser, namely, the length of period of manufacture. The merchandiser buys only finished products, and in order to attain a satisfactory turnover has only to stimulate the sales. The manufacturer, however, if his period of production is lengthy, will necessarily have a small ratio of turnover no matter what sales efforts he may put forth.
It would be impossible to state definite figures for turnover in the various lines of business. In general retail store merchandising, the turnover has been known to go as high as 8 or 10, but this is exceptional. Ordinarily 2, 3 or 4 - depending on the location of the store, the class of goods carried, and so on - would be regarded as a satisfactory turnover.
Investigations carried on by the Bureau of Business Research of Harvard University show that the rate of turnover in retail shoe stores ranges from 1 up to 3.6. The turnover in a large number of these stores was found to be 1.8, and the Bureau considers a turnover of 2.5 as a realizable standard in the average retail shoe store.*