What is Asset Turnover Ratio?
Definition: Asset turnover ratio measures of the efficiency with which the company can generate sales or revenue. The efficiency ratio compares the net sales of a business relative to its total assets. In essence what the ratios show is how efficient the company can be utilization of assets to generate returns.
The asset turnover ratio determines net sales of the company as a percentage of its assets to establish the amount of revenue realized from each dollar of its assets. For example, a 0.5 ratio indicates that every dollar of assets makes 50 cents of the sales.
Asset Turnover Ratio Explained
Since this is a measure of efficient utilization of assets by a company to generate sales the higher the ratio the more favorable it is. A higher ratio implies that the business is optimally generating revenue or sales from its assets while a low ratio is an indication of inefficient utilization of assets which shows that the company might be having internal issues.
The ratio is usually calculated annually and it differs across sectors and thus one can only compare ratios of firms operating in similar sectors. There are industry standards that the ratio depends on with some companies utilizing their assets efficiently while others don’t. For instance, in the retail industry companies have small total assets and high sales volume which means that their asset turnover ratio is likely to be high.
Likewise, companies in other industries like utilities require extensive amount of fixed assets. Thus, they tend to have a lower asset turnover ratio. This ratio is extremely important to creditors and investors since it gives a picture of how efficiently the company is able to use its assets to generate of sales. Equally, it provides insight into how a firm is using its fixed and current assets.
Asset Turnover Ratio Formula
Asset turnover ratio formula is calculated by dividing the company’s net sales by its average total assets as shown below:
Where:
Net sales (Revenue) = Annual sales (minus returns or refunds)
Beginning Assets= Assets at the start of the year
Ending assets = total end-year assets
Net sales of the company are used to compute the turnover asset ratio but refunds and returns should be removed from total sales, so that it can show the business’ ability to use it’s assets to generate sales.
Average assets is simply an average of total assets during the year based on a standard 2-year comparable balance sheet.
Asset Turnover Ratio Example
Let’s look at an example of how this equation is used in business and investing.
For instance, compare two companies company A and B.
| Total Assets | Company A | Company B |
| Beginning assets | $199,581 | $40,262 |
| Ending Assets | $198,825 | $37,431 |
| Average Total Assets | $199,203 | $38,846.5 |
| Sales | $458, 873 | $69, 495 |
| Asset Turnover Ratio | 2.30 | 1.79 |
When comparing the two companies, Company A has a turnover ratio of 2.3 while Company B has a turnover of 1.79. The asset turnover ratio of 2.30 for Company A means that it is generating 2.3 dollars of sales for each dollar invested while Company B is making 1.79 for each dollar it has invested in company assets.
As indicated before, a high asset turnover ratio means the business is uses its assets more efficiently and can generate more revenue with fewer assets. In this example, Company A is more efficient than Company B at generating sales with its resources.
Why is Asset Turnover Analysis Important?
For investors, the asset turnover ratio is very important because it’s used in comparing companies operating in the same industry to determine the company that is generating the most revenue from its assets.
Sometimes analysts can use other efficiency ratios like working capital and fixed-asset turnover to determine how efficient the company is at utilizing its assets to produce revenues. But a comparison of asset turnover ratios can only make sense if one is trying to compare companies within similar industries.