The asset turnover ratio is a financial metric that measures a company's efficiency in generating sales from its assets. A higher ratio indicates better efficiency. It's calculated by dividing the company's net sales by its average total assets.
You must look into the asset turnover ratio before making an investment decision because it tells you whether a company’s assets are sufficient to generate high sales — or if the company needs to rely on debt and/or equity to increase its revenue. If the company’s assets are enough to generate high turnover, it minimises the financial risk associated with debt and improves the Return on Investment (ROI) for investors.
Asset turnover ratio formula
The formula for the asset turnover ratio focuses on comparing a company’s total sales with its average assets. To compute the average assets, you need to take the average of a company’s assets at the beginning and the end of a financial year. Putting these together, we get the following asset turnover ratio formula:
Asset turnover ratio =
Total sales ÷ [(Assets at the year beginning + Assets at the year end) ÷ 2]
|
Since the asset turnover ratio is typically calculated once each financial year, the above formula is the common variant. However, if you are computing this ratio for a period shorter or longer than a year, you need to take the value of the company’s assets at the beginning and end of that period.
Example of asset turnover ratio
Let us examine how you can compute this ratio using the asset turnover ratio formula shown above, using hypothetical data for a company. Consider the following details for three different companies for a given financial year:
Particulars
|
Company A
|
Company B
|
Company C
|
Total sales
|
Rs. 20,00,000
|
Rs. 15,00,000
|
Rs. 30,00,000
|
Assets at the beginning of the year
|
Rs. 5,00,000
|
Rs. 4,00,000
|
Rs. 4,00,000
|
Asset at the end of the year
|
Rs. 7,00,000
|
Rs. 3,00,000
|
Rs. 6,50,000
|
Average assets
|
Rs. 6,00,000
|
Rs. 3,50,000
|
Rs. 5,25,000
|
Asset turnover ratio
|
3.33
|
4.28
|
5.71
|
In the above table, you can see that the three companies have vastly different asset turnover ratio values. Let us decode what they mean:
- Company A: Company A has a ratio of just 3.3 even though it has moderately high turnover among the three companies. This is because the company’s assets are far higher, but these assets are not efficiently used to generate revenue.
- Company B: Company B has lower sales than Company A. Nevertheless, it also has a lower total asset value. Since the company is utilising its assets efficiently to generate revenue, its asset turnover ratio is higher than that of company A.
- Company C: In addition to having more assets than Company B, Company C also has more total sales. This essentially means that the company is putting its assets to correct use and increasing its revenue efficiently, leading to a high asset turnover ratio.
Interpreting the asset turnover ratio
Broadly, a high value of the asset turnover ratio is considered a good sign. Here is how you can interpret this ratio.
- If the asset turnover ratio is less than 1: Say that a company has an asset turnover ratio of 0.75. This means that for every rupee invested in its assets, the company is only able to generate Rs. 0.75 as revenue. For investors, this is not an attractive proposition.
- If the asset turnover ratio is more than 1: If a company has an asset turnover ratio of 2.10, it means that for every rupee of its assets, the company generates Rs. 2.10 in sales. This is a more lucrative opportunity for investors because it indicates that the company can generate more revenue with less asset value.
The significance of the asset turnover ratio
While the asset turnover ratio can give you a fair idea of a company’s efficiency, it may not always present an accurate picture. The value of the asset turnover ratio may be skewed depending on how asset-heavy or asset-light an industry typically is.
For instance, companies in the retail sector do not generally have large investments in fixed assets. However, their revenue may be disproportionately high, leading to high values of the asset turnover ratio. On the contrary, in asset-heavy industries like real estate or construction, the revenue may not be consistently high year-on-year, leading to low asset turnover ratios.
How companies improve their asset turnover ratio
Since the general yardstick is that a high asset turnover ratio is better, companies keen on remaining attractive investments must focus on improving this ratio. Some measures commonly taken for this goal include:
- Creating new revenue channels
- Increasing annual sales
- Making inventory management more efficient
- Leasing or renting assets as opposed to purchasing them
- Liquidating assets in extreme cases
- Increasing current asset turnover by fast-tracking the collection of accounts receivables
- Focusing on efficiently using existing assets to increase revenue or turnover
- Outsourcing non-core activities that may otherwise tie up capital in assets
Limitations of the asset turnover ratio
Here are some limitations of asset turnover ratio
- Artificial inflation and deflation: Acquiring significant assets, such as new technologies, to anticipate future growth can artificially deflate the ratio. Conversely, selling assets in preparation for declining growth can artificially inflate the ratio.
- Impact of outsourcing: Outsourcing production facilities can lead to a higher asset turnover ratio due to a lower asset base, potentially making the company appear more efficient than competitors, even if profitability remains unchanged.
- Seasonal fluctuations: Seasonal businesses can experience significant variations in the asset turnover ratio throughout the year, making it difficult to draw accurate conclusions from a single-point-in-time measurement.
- Profitability dissociation: A high asset turnover ratio doesn't necessarily equate to high profitability. Ultimately, a company's ability to generate profit from its revenue is the true measure of performance.
- Year-to-year variability: The asset turnover ratio can fluctuate significantly from year to year. Therefore, analyzing trends in the ratio over time is crucial to identify potential improvements or declines in asset efficiency.
Conclusion
This sums up everything you need to know about what the asset turnover ratio is. While this ratio can offer some valuable insights into a company’s operational efficiency, you must think twice before you make an investment decision solely based on this ratio. It is always better to use the asset turnover ratio in conjunction with other metrics like the Return on Assets (ROA), gross and net profit margins and Return on Equity (ROE).
Related Articles
What-is-P/E-ratio
What is PCR ratio formula
What is EV to sales ratio
Know more price to sales ratio
PB ratio formula
