The asset turnover ratio evaluates the value of total sales to its total assets of a company. The asset turnover ratio is an efficiency ratio that gives an idea to the investors of how easily a company's management operates the business.
The ratio is an essential metric and it plays a crucial role in the DuPont analysis, where we break the return on equity (ROE) into three parts, one of them is the asset turnover ratio.
What is the Asset Turnover Ratio?
The asset turnover ratio is called the total asset turnover ratio that measures how efficiently a company utilizes its assets to generate sales. The proportion of net sales generated per rupee invested in assets.
In another word, the asset turnover ratio indicates to the investors how well a business is using its equipment to produce revenue.
A company has a high asset turnover ratio, which suggests a company more efficiently used its assets to generate revenue.
What is the Asset Turnover formula?
The asset turnover ratio formula is calculated by the net sales divided by average total assets.
Asset Turnover Ratio = (Net Sales / Average Total Assets)
Where,
Net Sales:
Net sales, also known as revenue that denote the company’s revenue after deducting sales returns, sales discounts and sales allowances. Net sales are reported on the income statement of a company.
Average Total Assets:
Average total assets are the average of aggregate assets at the end of the current year and aggregate assets at the end of the preceding year.
The total assets figure can be found on the balance sheet of a company. Even investors can take only the ending balance.
Asset Turnover Ratio Example
Suppose, it is an ABC company. Here is some information about the ABC company.
| Beginning Assets | ₹200,000 |
| Ending Assets | ₹210,000 |
| Average Total Assets | ₹205,000 |
| Total Sales | ₹395,000 |
Asset Turnover = (395,000 / 205,000)
Asset Turnover = 1.92 times
The asset turnover ratio of 1.92 times means that ABC company is able to generate a sale of Rs 1.92 while using fixed assets worth Rs 1.
How do you interpret the Asset Turnover Ratio?
The asset turnover is the efficiency ratio that illustrates how effectively the company uses its plants and equipment.
The higher asset turnover ratio is better for the company. Some sectors have a higher asset turnover ratio compared to others.
For example, retail and consumer staples businesses have relatively lower asset bases but they have high sales capacities - hence, these businesses have a higher asset turnover ratio.
While machine manufacturing and telecom sectors tend to have large asset bases. Hence, capital-intensive industry sectors have a lower asset turnover ratio.
Normally, a higher asset turnover ratio indicates the efficiency of a business regarding the use of assets for improved sales and a lower amount invested in assets generates more sales.
A higher turnover ratio reflects that the company is producing more revenue per rupee of assets.
A lower asset turnover ratio implies inefficiency in the use of the assets for generating sales.
The lower turnover ratio may indicate the business is holding extra production capacities and poor collection arising in doubtful debt allowances.
However, the asset turnover ratio is to benchmark the company against the other companies within a similar sector.
It is more important to keep up within the same sector because this ratio can highly vary from one industry to another industry.
What is the difference between asset turnover and fixed asset turnover?
While computing the asset turnover ratio, investors take average total assets in the denominator where the fixed asset turnover ratio considers only fixed assets.
The fixed asset turnover ratio is the efficiency ratio that shows how effectively a company is using its fixed assets to produce sales.
The proportion of net sales generated per rupee invested in fixed assets. The fixed assets would be property, plant and equipment.
The fixed asset balance is depreciation every year throughout the useful life of the asset.
Normally, a higher fixed asset ratio indicates the efficiency of the management regarding utilization of fixed assets for increased sales and a lower amount invested in fixed assets produce more sales.
What are the limitations of the Asset Turnover Ratio?
Every ratio has a positive side as well as a negative side. Similarly, the asset turnover ratio has some limitations are following:
1. Asset turnover ratio does not measure the profitability of a company, it only measures how efficiently a company is producing sales. It is preferable to use the asset turnover ratio with other ratios also.
This ratio does not provide a clear picture of the company. If investors want to check the profitability of a company, they can use the return on assets (ROA) ratio.
2. The asset turnover ratio contains all assets of a company and even considers those assets which are not used in production.
Hence, the outcome of the ratio can be wrong based on the list of the real assets used and all assets do not contribute at all.
FAQs
1. What is a good asset turnover ratio?
Asset turnover ratio would vary over various industry sectors. Most of the analysts prefer a ratio of above 1.0 and is considered good.
For example, retail or service sectors business has lower asset bases and much higher sales volume.
Whereas, real estate or manufacturing businesses tend to have large asset bases that illustrate a lower asset turnover.
A smart investor uses the asset turnover ratio with other ratios because it would get a more accurate picture of the performance of a company.
2. What is the total asset turnover ratio formula?
The asset turnover ratio can be calculated by the total sales divided by average total assets.
Asset Turnover Ratio = (Total Sales / Average Total Assets)
3. How to improve the asset turnover ratio?
There are several ways to improve asset turnover ratio as follows:
(a) Increase in Sales
The most common way to improve the asset turnover ratio is to discover a way to increase sales volume. The company will need to increase sales volume by the use of marketing and advertising.
(b) Sold Unused or Obsolete Assets
The company should sell obsolete or unused assets immediately. Because the company does not use those assets. Hence, the company should sell those assets that do not add any value to the company.
(c) Lease Assets
The company can lease the assets instead of purchasing new assets. It is the simplest way to improve the asset turnover ratio.
(d) Improve Efficiency
The company should properly utilize the assets and improve the productivity of all assets. If the company use the assets inefficiency way, the asset turnover ratio would be lower
4. Is a low asset turnover ratio good?
A higher asset turnover ratio is always preferable to the investors, a company is efficiently using its assets. A lower asset turnover ratio is not efficiently utilizing its assets.
