The asset turnover ratio is an essential financial ratio used to understand how effective a company is at using its assets to create revenue. The ratio can be used to determine a company’s performance. If the ratio is high, performance is good. It computes the net sales as a percentage of assets to show how much each dollar of a company’s assets generates revenue.
If a company has a total asset turnover ratio 0f 0.7, 70 cents are generated for each dollar of assets invested. The age of the assets in two similar companies will affect their asset turnover ratio. A high asset turnover may be seen in companies with older assets compared to a company with the same revenue but is new.
Formula
It is calculated by taking the net sales and dividing it by the company’s average total assets. The total assets and revenue generated are found on the balance sheet and income statement, respectively.
Asset Turnover Ratio = Total Sales / Average Total Assets
Net sales are the amount generated by a business after discounts, allowances for missing goods or damaged, and cost of returns. The company’s average total assets are the average of both long-term and short-term assets for the past two years recorded on its balance sheet. The asset turnover ratio is calculated on an annual basis.
Example
At the beginning of a company, the assets were $100000 and $150000 at the end of the year. The net sales were worth $50000.
Average Total Assets = $100000 + $150000 = $250000 / 2 = $125000
Asset Turnover Ratio= $50000 \ $125000 = 0.4
For every dollar invested in assets during that year, $0.4 was generated.
Importance of the Asset Turnover Ratio
A ratio that measures efficiency is important as it shows a company’s ability to utilize its assets to make sales revenue. A higher ratio shows that a business is getting more revenue from existing assets. It means the company’s assets are being put into good use other than being idle.
A lower asset turnover ratio signifies poor efficiency with which a company operates, which could be due to poor use of fixed assets, lacking collection methods, or limited inventory management. The low ratio means the company has potential assets that can generate revenue, but they are not being used. The ratio helps businesses to plan ways to increase revenue by making use of new and existing assets. External stakeholders such as the creditor and investors can use the asset turnover ratio or the fixed asset turnover ratio to assess its management team.
Improving Assets Turnover
- Low asset turnover can be due to uncollected invoices, inventory problems, production problems, and slow sales. Therefore, strategic planning is needed to increase the business’s efficiency and productivity.
- Managing inventory: A low asset turnover could be a result of too much stock. Inventories are illiquid and can take a longer time to be converted into cash. Businesses should learn to forecast their sales to balance with the demand to avoid holding too much inventory.
- Increase sales: Most of the time, a low asset turnover is the result of slow sales. Sales can be increased by expanding into new markets or concentrating more on products that generate more revenue. Also, offering a new product that does not require investing more money into assets can be introduced.
- Improve invoice collection: It can be achieved by amending the company’s invoice terms or engaging a collecting agency to pursue bad customer accounts.
- Utilizing the economics of scales: when making use of warehouses and large stores, it helps reduce production, delivery, and selling of goods and services while increasing the net profits and the asset turnover ratio. Perform regular maintenance on the warehouse or store equipment to reduce unit costs and downtime.
- Leasing long-term assets: A business can opt to lease machinery or equipment instead of buying. The company can easily upgrade the assets after the lease is over without incurring the depreciating value on their accounts or thinking about how to dispose of them.
- Selling products and services with a high margin: These can result in high net sales compared to assets employed in generating sales. It will increase the profitability ratio as well as the turnover ratio.
Limitations
- Some companies lease assets, which reduce the company’s asset base giving a high ratio.
- The ratio only serves as a meaningful tool for analyzing companies with large assets instead of those with few assets or service based industries.
- Companies can artificially inflate the ratio by selling off assets when anticipating a growth decline.
- It is preferable to use the ratio to compare companies within the same industry than making comparisons across industries.
The asset turnover ratio is an efficiency ratio and it is one of the best ways to tells how well a company is utilizing assets to create revenue. It is good to regularly monitor the business asset turnover ratio as it will help in planning and boost profitability.
