The revenues generated by a company are an important measure of its profitability and standing. You can compare the profitability of a business against its assets employed using the asset turnover ratio.
But what is this ratio? Let’s find out!
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What Is the asset turnover ratio?
The asset turnover ratio, or the total asset turnover ratio, measures how well a company deploys its assets to generate income. In this sense, the asset turnover ratio compares the assets of a company against the revenues generated.
Naturally, a high turnover depicts that a business is well employing its assets to generate revenue. Now a low asset turnover ratio could mean that the business needs to be more utilised in its assets or leverage them gainfully to earn revenue.
Return on equity: Highlights
- The asset turnover ratio depicts how well a company utilise and deploys its assets for every unit of sale.
- Investors and stakeholders use the ratio to judge a company’s performance and gauge how much revenue is being generated through its assets.
- The higher the ratio, the better the company is at employing its assets.
- It is paramount to compare this ratio only to companies in the same sector or industry.
Formula, example and calculation of the asset turnover ratio
This ratio is fairly simple to calculate. The asset turnover ratio formula is as below –
Asset turnover ratio = Net sales/Average total assets
Remember, different industries can have different asset turnover ratio values.
Let’s quickly understand the asset turnover ratio with an example.
Assume XYZ Company is a car manufacturing company currently looking for new investors and has a meeting with an angel investor. The investor wants to know how well the company uses its assets to produce sales. The following are the details found in the company’s financial statements.
Opening assets: Rs. 10,000
Closing assets: Rs. 50,000
Net sales: 5,000
So the total asset turnover ratio of XYZ Company is:
5000/ (10000+50000)/2 = 0.16
XYZ’s asset turnover ratio is only 0.16. This means that for every rupee in assets, the company only generates an income of 16 paise. This can conclude that XYZ Company could be more efficient with its use of assets.
Interpretation of asset turnover ratio
The asset turnover ratio determines how effectively a company uses its assets to generate sales or revenue. Now, this value can be influenced by several factors. For instance, a low ratio may indicate inadequate inventory management or excessive production capacity and more. A low asset turnover ratio could be seen as a red flag.
Additionally, the asset turnover ratio may be higher for some industries than others. Take the example of retail. Despite lesser assets, this sector has a high turnover ratio! While conversely, the healthcare sector, with an impressive and large asset spread, does not enjoy a high turnover ratio. In this sense, comparisons are helpful when made between companies in the same industry.
Therefore, by benchmarking and comparing the asset turnover ratio to the industry average, you can establish whether it is functioning well.
Advantages of asset turnover ratio
The asset turnover ratio has wide importance for investors and may influence their investing decisions. Read further to know about the advantages.
- Measure company performance – The asset turnover ratio is one method used to analyse a company’s performance. And as investors constantly look for investment opportunities, a high asset turnover ratio could attract new investors.
- Saves extra expenditure– Management should consider the advantages an asset offers before purchasing it. This can help cut down on wasteful spending.
- Facilitate comparison – It is a measure used by investors to compare one company with another within the same sector before any decision-making.
- Indication of asset impairment – The ratio can indicate asset impairment. For instance, a sudden drop in the ratio may indicate that the company assets are losing their ability to generate income.
Limitations of assets turnover ratio
- The asset turnover ratio does not offer all the information necessary for thorough research.
- It does not exclude the idle assets that are not employed in the production process, providing an inaccurate result.
- The asset turnover ratio of a company may vary significantly for different accounting periods, making comparison difficult.
- When a business makes substantial asset purchases in anticipation of faster expansion, the asset turnover ratio might be unnaturally lowered. Similar selling off assets may unnaturally raise the ratio. The asset turnover ratio of a company thus remains impacted by a variety of factors and cannot be taken at face value.
What is the fixed asset turnover ratio?
The fixed asset turnover ratio is a ratio that depicts how well an organisation deploys its fixed assets to generate revenue.
The formula of the fixed asset turnover ratio is as below –
Fixed asset turnover ratio = Net sales or revenue / Average fixed assets
The difference between asset turnover ratio and fixed asset turnover ratio
| Basis | Asset turnover ratio | Fixed asset turnover ratio |
| Meaning | This ratio depicts the sales value of a business generated for each unit of an asset utilised. | Refers to the relationship between the value of sales and the value of a company’s fixed assets, specifically its property, plant, and equipment. |
| Calculation | It is calculated by dividing the net sales by the average asset value. | It is calculated by subtracting the average net fixed assets from the net sales revenue. |
| Use of Assets | Includes all assets | Includes only fixed assets |
| Importance | Helps firms compare businesses in the same sector to evaluate how well they can use available assets to generate income and identifies internal flaws in a company. | Determines if new fixed assets improve sales and evaluate the effectiveness of existing fixed assets. |
| Shortcomings | In situations where a new major asset is purchased or sold, it might not provide an accurate image. | It can present a deceptive image in businesses with seasonal sales. Companies with high fixed asset turnover may still experience losses because it does not reflect a stable cash flow. |
Is it better to have a high or low asset turnover?
Generally, a high asset turnover ratio is preferred. This is because a high ratio shows that the company is successful in employing its assets to a good capacity. Conversely, a low turnover ratio may tell an investor that the organisation needs to deploy its assets to their maximum potential.
Importantly, you could be misreading this ratio if you compare companies from different sectors. Lastly, regardless of the asset turnover ratio, a company has to perform well on various metrics and valuations to qualify as an investment option.
Conclusion
The asset turnover ratio is a measure that contrasts revenues with assets. A company with a high asset turnover ratio may attract higher investors. Like other indicators, the asset turnover ratio works best when compared to companies in the same sector. Understand the asset turnover ratio to choose the companies that are utilising their assets efficiently.
