Asset turnover ratio is an important financial ratio used to understand how well the company is utilizing its assets to generate revenue. It is imperative for every company to analyze and improve Asset Turnover Ratio (ATR). The article highlights the reasons and ways to analyze and interpret asset turnover ratio as an important part of ratio analysis.
Definition of Asset Turnover Ratio
Asset turnover ratio is the ratio between the value of a company’s sales or revenues and the value of its assets. It is an indicator of the efficiency with which a company is deploying its assets to produce the revenue. Thus, asset turnover ratio can be a determinant of a company’s performance. The higher the ratio, the better is the company’s performance. Asset turnover ratio can be different from company to company. Usually, it is calculated on an annual basis for a specific financial year.
Meaning of Asset Turnover Ratio
Asset turnover (total asset turnover) is a financial ratio that measures the efficiency of a company’s use of its assets to product sales. It is a measure of how efficiently management is using the assets at its disposal to promote sales. The ratio helps to measure the productivity of a company’s assets.
Asset turnover ratio shows the comparison between the net sales and the average assets of the company. An asset turnover ratio of 4 means, for every 1 USD worth of assets, 4 USD worth of sale is generated. So, a higher asset turnover ratio is preferred as it reflects more efficient asset utilization.
Some industries are designed to use assets in a better way than others. A higher asset turnover ratio implies that the company is more efficient at using its assets. A low asset turnover ratio, on the other hand, reflects the bad management of assets by the company. It may also indicate production or management problems.
Formula of Asset Turnover Ratio
Asset turnover ratio is the ratio of a company’s net sales to its assets.
Net sales are listed on your income statement and are your total revenues less your returns, allowances, and any discounts you may have provided.
Net Sales = Total Revenues - Returns - Allowances - Discounts
Total assets are the value of all of your assets, found on your balance statement. Your total assets can include cash, accounts receivable, fixed assets, and current assets.
Current assets are assets you expect will be converted to cash within a year’s time. These assets could include accounts receivable, inventory, or any other type of asset that is liquid—in this context, liquid refers to the ability to turn the asset into cash.
Fixed assets do not get converted into cash. Buildings and equipment that your business keeps and uses are examples of fixed assets. If you sell used equipment, then the equipment you sell would be a current asset, whereas the equipment you keep for running your business is a fixed asset.
Accounts Receivable are the accounts you have allowed customers to use credit to purchase on. Expected revenues are an asset.
Total Assets = Cash + Accounts Receivable + Fixed Assets + Current Assets
The formula for the asset turnover ratio is:
Total Asset Turnover = Net sales ÷ Total assets
There are several problems with the ratio, which are:
- The measure assumes that additional sales are good, when in reality the true measure of performance is the ability to generate a profit from sales. Thus, a high turnover ratio does not necessarily result in more profits.
- The ratio is only useful in the more capital-intensive industries, usually involving the production of goods. A services industry typically has a far smaller asset base, which makes the ratio less relevant.
- A company may have chosen to outsource its production facilities, in which case it has a much lower asset base than its competitors. This can result in a much higher turnover level, even if the company is no more profitable than its competitors.
- A company may be penalized for deliberately increasing its assets to improve its competitive posture, such as by increasing inventory levels in order to fulfill more customer orders within a short period of time.
- The denominator includes accumulated depreciation, which varies based on a company’s policy regarding the use of accelerated depreciation. This has nothing to do with actual performance, but can skew the results of the measurement.
In general, the return on assets measure is better than the total asset turnover ratio, since it places the emphasis on profits, rather than sales.
Why Does the Asset Turnover Ratio Matter?
In general, a low asset turnover ratio suggests problems with excess production capacity, poor inventory management, or lax collection methods. Increases in the asset turnover ratio over time may indicate a company is “growing into” its capacity (while a decreasing ratio may indicate the opposite), but remember that asset purchases made in anticipation of coming growth (or the sale of unnecessary assets in anticipation of declining growth) can suddenly and somewhat artificially change a company’s asset turnover ratio.
Low-margin industries tend to have higher asset turnover ratios than high-margin industries because low-margin industries must offset lower per-unit profits with higher unit-sales volume. Additionally, capital-intensive companies will typically have lower asset turnover ratios than companies using fewer assets. This is why comparison of asset turnover ratios is generally most meaningful among companies within the same industry, and the definition of a “high” or “low” ratio should be made within this context.
This ratio measures how efficiently a firm uses its assets to generate sales, so a higher ratio is always more favorable. Higher turnover ratios mean the company is using its assets more efficiently. Lower ratios mean that the company isn’t using its assets efficiently and most likely have management or production problems.
For instance, a ratio of 1 means that the net sales of a company equals the average total assets for the year. In other words, the company is generating 1 dollar of sales for every dollar invested in assets.
Like with most ratios, the asset turnover ratio is based on industry standards. Some industries use assets more efficiently than others. To get a true sense of how well a company’s assets are being used, it must be compared to other companies in its industry.
The total asset turnover ratio is a general efficiency ratio that measures how efficiently a company uses all of its assets. This gives investors and creditors an idea of how a company is managed and uses its assets to produce products and sales.
Sometimes investors also want to see how companies use more specific assets like fixed assets and current assets. The fixed asset turnover ratio and the working capital ratio are turnover ratios similar to the asset turnover ratio that are often used to calculate the efficiency of these asset classes.
Why is it Necessary to Improve Asset Turnover Ratio?
Since asset turnover ratio measures the efficiency of a company in managing its resources to generate its sales, it is very obvious that higher turnover ratios are preferred to reflect a better state of affairs at the company. This ratio gives an insight to the creditors and investors into the internal management of the company. A low asset turnover ratio will surely signify excess production, bad inventory management or poor collection practices. Thus, it is very important to improve the asset turnover ratio of a company.
Asset Turnover in Relation to Profit
Asset turnover is a key element in a commonly used measure of profitability: the return on assets ratio. Return on assets measures how well a company uses assets to generate profit, not just sales revenue. The formula for return on assets is Net Income divided by Average Total Assets. Notice that if you multiply asset turnover (Sales divided by Average Total Assets) by profit margin (Net Income divided by Sales), you get Net Income divided by Average Total Assets – in other words, return on assets. In general, companies with high asset turnover tend to have low profit margins, while those with low turnover tend to have higher profit margins.
Asset Turnover Ratio Conclusion
The Asset Turnover Ratio provides a comparison between the net sales and the average assets of a business or company with a higher ratio implying utilization of the company assets in production and vice versa. The following points are a recap of the entire article.
- Asset turnover ratio measures how well a company will be able to combine all its assets to produce sales or revenues in a given year
- The efficiency ratio compares a company’s net sales with average total sales.
- Asset turnover ratio is expressed as a numeric and not as a percentage.
- Using this ratio to compare companies in the same industry will be preferable than comparing companies across industries.
- Assets intensive industries will register a higher ratio than brain driven service industries.
- Higher asset turnover ratio is favorable as it is an indication that a company is making good use of its assets.
- A low asset turnover ratio indicates inefficiency in production.
- The ratio provides insights to creditors as well as investors on the wellbeing of a company.