Asset turnover ratio is a calculation used to measure the value of a company’s assets relative to its sales or revenue. It’s used to evaluate how well a company is doing at using its assets to generate revenue.
Similar to cash flow, the asset turnover ratio compares the company’s total assets over the course of a year to its sales. In simpler terms, it shows the dollar amount the company is earning in sales compared to the dollar amount of its assets. It can be calculated annually or over a shorter or longer period of time.
Why is Asset Turnover Ratio Important?
Although having cash on hand is important for growing and maintaining a business, other types of business assets are also important, as is how a company chooses to use them. Liquid assets can include cash, stock, and anything else the company owns that could be easily liquidated into cash. Fixed assets are things the company owns that are not as easily turned into cash. This could include real estate, copyrights, equipment, etc.
For business owners, asset turnover ratio can be important when applying for loans and learning about their company’s cash flow. A higher asset turnover ratio indicates that a company is efficiently generating sales from its assets, while a low ratio indicates that it isn’t. A higher asset turnover ratio also shows that a company’s assets don’t need to be replaced or discarded, that they are still in good condition.
A higher ratio is preferable for investors, as well. Investors can look at the asset turnover ratio when evaluating the risk of investing in a company, or when comparing similar companies to one another. Each industry has different norms for asset turnover ratios, so it’s best to only compare companies within the same sector. For instance, a utility company or construction company is more likely to have a higher number of assets than a retail company.
Formula for Calculating Asset Turnover Ratio
It’s very simple to calculate asset turnover ratio, which is one reason it’s such a useful tool for investors. Asset turnover ratio can be calculated using the following formula, which divides total (net) sales or revenue by average total assets:
Asset turnover = Net Sales / Average Total Assets
Which can also be shown as:
Asset turnover = Net Sales / ((Beginning Assets + Ending Assets) / 2 )
Where:
Net Sales = Gross annual sales minus returns, allowances, and discounts. Total sales can be found on a company’s income statement (typically part of an earnings report).
Beginning Assets = Assets at the beginning of the year
Ending Assets = Assets at the end of the year
Total Assets = Generally a company will include calculated average total assets on their balance sheet. However, sometimes additional calculations will need to be made.
Calculating Total Assets
The value of a company’s total assets includes the value of its fixed assets, current assets, accounts receivable, and liquid assets (cash).
• Accounts receivable are accounts that hold expected revenues that come from when customers use credit to buy goods and services.
• Fixed assets are generally physical items such as equipment or real estate.
• Current assets are things that the company predicts will be converted into cash within the next year, such as inventory or accounts receivable that will be liquidated.
The formula for calculating total assets is:
Total Assets = Cash + Accounts Receivable + Fixed Assets + Current Assets
Example of Calculating Asset Turnover Ratio
To give an example of the ratio calculation, if a company has $2,000,000 in average assets and $500,000 in sales over the course of a year, the calculation of its asset turnover would be:
500,000 / 2,000,000 = 0.25 = 25% asset turnover ratio
What this means is that the company’s assets generated 25% of net sales over the course of the year. In other words, every $1 in assets that the company owns generated 25 cents in net sales revenue.
Factors that can Cause Low Asset Turnover
There are several reasons why a company might have a low asset turnover. These include:
• More production capacity than is needed
• Inadequate inventory management
• Poor methods of customer money transaction
• Poor use of fixed assets
The ratio can also change significantly from year to year, so just because it’s low one year doesn’t mean it will remain low over time.
What is a Good Asset Turnover Ratio?
Investors can use the asset turnover ratio as part of comparing and evaluating stocks. But what is considered a good number for asset turnover?
In general, the higher the number the better—and a number higher than 1 is ideal. This is because a value greater than 1 means the dollar value generated by assets is greater than the dollar amount that the assets cost. A higher number means a company is generating sales efficiently and not wasting assets. An amount less than 1 means that assets are generating less than the amount of their dollar value. If a company isn’t effective at generating sales with its assets, it most likely wouldn’t be a great investment.
Since each industry has its own standards for a “good” asset turnover ratio, there isn’t one specific number to look for. For companies in the utilities industry, ratios are generally lower than companies in retail.
Companies can work on improving their asset turnover ratio by increasing sales, decreasing manufacturing costs, and improving their inventory management. Other ways they can improve include adding new products and services that don’t require the use of assets, and selling any unsold inventory still on hand.
Limitations of Using Asset Turnover Ratio
While asset turnover ratio is a useful tool for evaluating companies, like any calculation, it has its limitations. It is useful for comparing similar companies, but isn’t a sufficient tool for doing a complete stock analysis of any particular company.
Also, a company’s asset turnover ratio could vary widely from year to year, making it an unreliable measure for potential long-term investments. Even if the ratio has been similar in years past, this doesn’t mean it will continue to remain consistent. However, investors can look at the long term trendline of the ratio to get a general indication of whether it’s improving or not.
Since asset turnover is typically calculated once a year, if a company made even a few large purchases this could skew their ratio. This is fairly common, as companies might have certain monthly expenses but occasionally need to invest large sums of money into equipment, office renovations, or other common business needs.
Other ratios that can be used to gain an understanding of a company’s financials are the debt-to-equity ratio and P/E ratio.
The Takeaway
Knowing how to calculate asset turnover ratio can be useful for investors who are evaluating companies as they start building an investment portfolio. While the formula is simple—Asset turnover = Net Sales / Average Total Assets—it’s important to remember that the calculations work best when comparing companies within one industry, rather than across various industries. Additionally, there are other metrics by which to evaluate a company or value its stock.
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