The Asset Turnover Ratio measures how efficiently management uses the company’s assets to generate sales revenue. The ratio compares the amount of net sales to its total assets. It’s a standard efficiency ratio, as it gives investors an idea of how well management runs the company.
What is the Asset Turnover Ratio
The ratio, also known as the Total Asset Turnover Ratio, can determine the company’s performance and an excellent indicator of management’s efficiency. We usually calculate it on an annual basis, but we can implement it for various periods.
The metric is a crucial part of the DuPont analysis, where we split the Return on Equity (ROE) into three components, one of which is the Asset Turnover Ratio.
Investors find the ratio particularly useful when evaluating how effectively companies use their assets to generate sales. It is common to compare businesses with a portfolio of similar investments to identify potential problems.
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Net sales represent the company’s revenue after deducting returns, discounts, and allowances for uncollectible receivables.
Average assets are the average between the opening and closing balances. If we are facing issues with data limitations, we can also use the ending balance. If we identify significant fluctuations in the balance of assets near one end of the period, we can employ a weighted average calculation.
We can break down assets into fixed assets and working capital to prepare a more detailed analysis. We can look into these classes by employing the Fixed Assets Turnover Ratio and the Working Capital Turnover Ratio.
Analyzing the Ratio
As with most ratios, we use the Asset Turnover Ratio to benchmark the business against other companies within the same industry sector. It is essential to stay within the same industry, as different ones may have completely different average ratios. Comparing metrics between particular industries is not appropriate due to their highly varying capital structures.
For example, retail businesses generally have a much lower asset base, as they have small production capacities, while machine manufacturing entities tend to have more assets. In practice, capital-intensive industry sectors generally have a slower turnover of assets.
Usually, we prefer a higher ratio, which indicates the company makes fair use of its asset base. It also means the business is productive, and it generates little waste in its operations. This shows that assets still retain their value, and no replacement is necessary. Low-margin industries tend to have a higher Asset Turnover Ratio, which is indicative of their pricing strategy.
If the business is experiencing lower ratios, this may indicate internal problems.
A lower ratio can also result from one or more factors, some of which can be:
- The company is holding excess production capacities;
- Low collection resulting in doubtful debt allowances;
- Lousy inventory management leading to slow-moving or obsolete stock at hand.
Broadly, most analysts consider a ratio of above 1.0 to be good. However, as the Asset Turnover Ratio varies a lot between industries, there’s no universal value to strive towards. It is essential to be knowledgeable about your industry to come up with the proper target to benchmark against.
Reading the ratio is quite simple. Let’s say we calculate the Asset Turnover Ratio to be 0.7. This means that every single euro of asset value has generated €0.70 of revenue in the analyzed period.
A common approach is to look at the metric over time and see how it develops.
Keep in mind that the ratio does not look into the profitability of the company; only how well it generates sales. It is a great idea to combine the Asset Turnover Ratio with others, so management can get a better picture of the performance and make more informed decisions. For example, to look into profitability, we can use the Return on Assets (ROA) ratio.
Improve your Asset Turnover Ratio
One of the ways to improve the ratio is to find ways to increase net sales. We have to achieve that through efficiency improvements, not by introducing new product lines with additional manufacturing equipment.
We can work on minimizing returns by providing an improved customer experience and better support. We can also improve our credit control and collection practices, which will lead to less doubtful debt allowances. Or we can try to find additional revenue streams that require no investment in new assets.
Another option to improve the Asset Turnover Ratio is to decrease the company’s total assets in the balance sheet. Clearing old slow-moving inventory and selling off unused production capacities will improve the ratio and cash inflow.
Example Asset Turnover Ratio Analysis
Let’s explore the ratio and look at how it can be helpful for the company.
First, we need to look at our income statement to get our sales. As we don’t have information on net sales, we will further adjust these in our calculation.
Next, we look at the balance sheet to extract the total assets’ balances for each year.
Starting our Asset Turnover Ratio calculation, we first need to adjust sales. As we don’t have detailed data on returns and doubtful debt allowances, we can use the average percentages we know from experience. These are 2.1% for returns and 1.7% for allowances. Subtracting these from the revenue will give us Net Sales.
As we advance, we can use the closing balance of the previous period as the opening balance for the current period and calculate the Average Assets value. For FY 2016, we have no opening balance, so we use the closing balance for our calculation.
Now that we have calculated the Asset Turnover Ratio for each period, we can plot them and look into the development over the five years.
There are some fluctuations in the ratio over time. The overall trend is going upwards, indicating management has improved the business operations’ efficiency over the past years.
The Asset Turnover Ratio is a preferred metric for investors, mostly independent of the company’s size. It can be indicative of internal problems, and it’s crucial to look at it over time. If it’s on the low side, there are many ways we can try to improve it, like enhanced product lines, fewer returns, and less doubtful debt allowances.
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