What is the Asset Turnover Ratio?

What is the Asset Turnover Ratio?

Asset turnover ratio is the ratio between the value of a company’s sales or revenues and the value of its assets. It is an indicator of the efficiency with which a company is deploying its assets to produce the revenue. Thus, asset turnover ratio can be a determinant of a company’s performance.

The higher the ratio, the better is the company’s performance. Asset turnover ratio can be different from company to company. Usually, it is calculated on an annual basis for a specific financial year.

Calculating the Asset Turnover Ratio

The asset turnover ratio compares performance from the income statement with the company’s financial health on the balance sheet. The formula is:

Asset Turnover Ratio = Net Sales / Average Total Assets

Net sales is the total amount of revenue retained by a company. It is the gross sales from a specific period less returns, allowances, or discounts taken by customers. When comparing the asset turnover ratio between companies, ensure the net sales calculations are being pulled from the same period.

Average total assets are found by taking the average of the beginning and ending assets of the period being analyzed. The standard asset turnover ratio considers all asset classes including current assets, long-term assets, and other assets.

The asset turnover ratio is expressed as a rational number that may be a whole number or may include a decimal. By dividing the number of days in the year by the asset turnover ratio, an investor can determine how many days it takes for the company to convert all of its assets into revenue.

See also :  What is Income Tax Payable?

Interpreting the Asset Turnover Ratio

Regardless of whether the total or fixed ratio is used, the metric does not say much by itself without a point of reference.

In practice, the ratio is most helpful when compared to that of industry peers and tracking how the ratio has trended over time.

  • Low Turnover ➝ Often indicates excess production capacity or inefficient inventory management
  • High Turnover ➝ Suggests the company is allocating capital and deriving more benefits from its assets

Comparisons of the ratio among companies are going to be most meaningful among those within the same vertical or industry and setting the parameters to determine what should be considered “high” or “low” ratios should be made within a specific industry context.

The average ratio varies significantly across different sectors, so it makes the most sense for only ratios of companies in the same or comparable sectors to be benchmarked.

Over time, positive increases in the turnover ratio can serve as an indication that a company is gradually expanding into its capacity as it matures (and the reverse for decreases across time).

All companies should strive to maximize the benefits received from their assets on hand, which tends to coincide with the objective of minimizing any operating waste.

On the flip side, a turnover ratio far exceeding the industry norm could be an indication that the company should be spending more and might be falling behind in terms of development.

Thus, a sustainable balance must be struck between being efficient while also spending enough to be at the forefront of any new industry shifts.

See also :  What is Cashback?

As with all financial ratios, a closer look is necessary to understand the company-specific factors that can impact the ratio. And such ratios should be viewed as indicators of internal or competitive advantages (e.g., management asset management) rather than being interpreted at face value without further inquiry.

For example, a company may have made significant asset purchases in anticipation of coming growth or have gotten rid of non-core assets in anticipation of stagnating or declining growth – and either change could artificially increase or decrease the ratio.

Another consideration when evaluating the ratio is how capital-intensive the industry that the company operates in is (i.e., asset-heavy or asset-lite).

Companies with fewer assets on their balance sheet (e.g., software companies) will typically have higher ratios than companies with business models that require significant spending on assets.

Limitations of Using the Asset Turnover Ratio

While the asset turnover ratio should be used to compare stocks that are similar, the metric does not provide all of the detail that would be helpful for stock analysis. It is possible that a company’s asset turnover ratio in any single year differs substantially from previous or subsequent years.

Investors should review the trend in the asset turnover ratio over time to determine whether asset usage is improving or deteriorating.

The asset turnover ratio may be artificially deflated when a company makes large asset purchases in anticipation of higher growth. Likewise, selling off assets to prepare for declining growth will artificially inflate the ratio.

Also, many other factors (such as seasonality) can affect a company’s asset turnover ratio during periods shorter than a year.