Capital Turnover = Sales / (Equity + Debt - Cash & Cash Equivalents)
In my model, this ratio is used to determine how much capital reinvestment (i.e. Working Capital and Capex combined) a company should make to obtain 1 unit of Sales/Revenues. So, a 2 Capital Turnover essentially means that the company can generate a Revenue of Rs. 2 from Rs. 1 of invested capital. If the company manages to contain its expenses and taxes within, say, Rs. 1.80, then its profits would be Rs. 0.2, which is representative of a 20% return on invested capital. I hope it’s clear up until this point.
The reason behind deducting Cash and Cash Equivalents is that, in any sensible Valuation, income generated from cash and cash equivalents (Such as dividends, interest income) are supposed to be ignored. Instead, Cash is simply taken at Face Value (Nothing more, nothing less). This is because the business and the cash do not carry the same amount of risk.
Say, if a company invests Rs. 100 Cr in Machinery and Rs. 15 Cr in Government Bonds, a logical conclusion is that the Rs. 100 Cr is at a far greater risk (Business Risk) than the Rs. 15 Cr (Governmental Default Risk–which is almost zero). Therefore, it makes sense to say that the proceeds from the Rs. 100 Cr should be discounted at the WACC and the proceeds from the Bond Investment at the Risk-free Rate. We do discount the proceeds of the ‘Machinery investment’ i.e. The Free Cash Flow at WACC.
But what about the relatively riskless Bond Investment? If the Bond Investment earns at the RfR and gets discounted at the RfR, its Value remains the same. That is, assuming a RfR of 8%, (15 Cr * 0.08)/0.08 = Rs. 15 Cr. This coincides with our logic of taking all Cash and Cash Equivalents at Face Value.
With that said, there is definitely a catch-22 situation with regards to Cash holdings. Prof. Aswath Damodaran addressed this problem in one of his blog posts:
He also wrote an extensive paper on the topic, if you’d like to go through it: SSRN-id841485.pdf (1.9 MB) (Warning: It’s 55 pages long)
The TLDR is: If you trust a company to reinvest cash holdings appropriately, it makes sense to simply ignore cash-related income and consider cash at Face Value. If you don’t, then it makes sense to ‘penalize’ the excess cash by reducing the Value of cash:
Say, a company has Rs. 100 Cr. You don’t trust the company to reinvest this cash properly. Assume that the WACC is 12% and RfR is 8%. You will simply do 100 * 0.08 / 0.12 = Rs. 66.67. So, in line with your doubts, you ‘penalized’ Rs. 33.33 worth of Cash holdings from the company. You can now use this reduced Value of Rs. 67 Cr in the Capital Turnover formula instead of the Rs. 100 Cr (Which will results in a lower Capital Turnover and so, lesser free cash flows).
Alternatively, you could include the earnings from cash and cash equivalents (Dividends, interest income) and let it all get discounted at the WACC. You don’t adjust anything. But the risk here is that you are also projecting income from cash out for many years, whereas income from cash tends to be very fickle. This is a part of the discussion I was having in another thread:
If all this is too complex, a simple thumb-rule is to ignore Cash completely from the equation. Use the ‘Non Operating Asset’ field in the model to populate Cash balance. Don’t include Cash while calculating Capital Turnover. This is a very conservative approach. The impact of this kind of a method can range from minimal (For a company like KRBL) to enormous (For a company like Cochin Shipyard).