If you're investing a lot of money in your business assets, you want to know that those assets are helping your company to hit its sales targets. Spending $20,000 or even $200,000 on machinery that is going to sit idle makes little commercial sense, and your business may not survive for long if you do. The asset turnover ratio is a useful metric, as it measures how efficiently you're using your assets to generate revenue.
TL;DR (Too Long; Didn't Read)
The asset turnover ratio shows how much revenue is generated by the company's assets. The higher the ratio, the more efficient the company is.
What Does Asset Turnover Mean?
Asset turnover is a way of expressing how well, or efficiently, the company is managing its resources to generate sales. In short, it reveals how much sales revenue the business is generating from every dollar's worth of assets it has on its books. Those assets could be anything from machinery, vehicles and real estate to accounts receivable and cash in the bank. Every business needs to know how hard its assets are working so it can make decisions about how to use them. If you have low asset turnover, for example, it might indicate that you have excess production capacity or you aren't managing your inventory properly to maximize sales.
What Is the Asset Turnover Ratio Formula?
To calculate the asset turnover ratio for any given period, divide your Net Sales Revenue by your Average Total Assets for the same period:
Asset turnover ratio = Net sales revenue/ Average total assets
The simplest and most common way to determine the "Average Total Assets" figure is by adding the value of your Beginning Total Assets to the value of your Ending Total Assets, and dividing the total by two:
Average total assets = (Beginning total assets + Ending total assets)/ 2
So, if your business began the year with $50,000 in assets and ended it with $60,000, your total average assets would be $55,000. For new businesses that do not have two years' worth of data, simply use your Ending Total Assets as a proxy for Average Total Assets. You can find the sales revenue figure on your income statement. The asset figures appear on your balance sheet.
How Do The Calculations Work in Practice?
To show how the asset turnover calculation works, suppose that company ABC Limited has sales revenue of $94,000 for the year ended December 31, 2017. Looking at the assets section of its balance sheet, you see that ABC had total assets of $8,300 for the year ending 2016, and total assets of $18,300 for the year ending 2017. As a reminder, the asset turnover ratio formula is:
Asset turnover ratio = Net sales revenue/ Average total assets
So, for 2017, ABC's asset turnover ratio is:
94,000/ ( (8,300 + 18.300)/2) = 7.07
This means that for every dollar of ABC Limited's assets, the company generated over $7 worth of revenue. Another way of expressing this is as a "times" figure, meaning ABC's assets generated seven times the amount of revenue compared to the cost of the assets.
How Do You Interpret Asset Turnover Ratio?
This is a ratio where the higher the number, the better. A high number means that your fixed assets are working optimally to generate cash for your business. A low asset turnover ratio, on the other hand, shows that something is wrong. You are not using your assets as efficiently as you could, and you may need to look at your production processes to figure out where the problem is. Generally, a low asset turnover ratio shows that you have excess production capacity that you're just not filling, so your assets are underused. It may also signify lax collection practices or that you're not managing your inventory efficiently, among other problems.
What Is a Good Asset Turnover Ratio?
As with other ratios, whether the number you get is a good or bad number depends on the industry in which your company operates. Some industries are more asset-intensive than others, so their asset turnover ratio will be lower. A management consultancy, for instance, runs primarily on the expertise of its consultants. It doesn't need many fixed assets to perform services for clients and to generate revenue. Compare that to a haulage or mining company where assets are the backbone of the business, and it's easy to see how different industries will have a very different asset turnover ratio benchmark.
To find the appropriate benchmark for your business, you must compare apples with apples. Comparisons are only meaningful among organizations in the same industry, and the definition of a "good" or "bad" ratio should be made within this context.
How Do You Use the Asset Turnover Ratio to Spot Trends?
Like all accounting ratios, the asset turnover ratio gives a snapshot of the company's efficiency at a fixed point in time. The real measure of how well you're doing is whether the ratio is going up or down over several accounting periods; ideally, you'll want the ratio to increase, not deteriorate.
If you see your asset turnover ratio going down from period-to-period when your sales revenue is the same, it could be a sign that you have too much capacity in your assets that is not being used. In other words, you've over-invested, purchasing more vehicles, buildings or machinery than you can use. Again, context is important, and if you've made a series of asset purchases in anticipation of future growth, then your ratio may take an artificial nosedive. It's important not to panic, as your ratio should soon come back up as revenues start to output from your sales engine.
If your ratio is increasing, it could be a sign that you are growing into your production capacity and are becoming more efficient. However, it could just as easily mean that you are stretched to your capacity in terms of your production. A rising ratio, year-after-year, could be a signal that you need to invest in some additional business assets to grow.
How Do You Increase Asset Turnover Ratio?
Since the asset turnover ratio compares the company's net sales to the average assets of the company, it stands to reason that you're going to have to improve one or both of those inputs to increase the ratio. Here are some techniques to consider:
A period of slow sales could result in a low asset turnover ratio even if your assets are properly utilized. Boosting those sales is often the easiest way to improve your number. Could you run a marketing campaign, hold a promotion or tweak your pricing strategy to improve the sales of your finished goods?
Selling obsolete assets:
There is not much sense in retaining unused or underused assets that are not producing income. Liquidating those assets can give you a quick cash injection, which you can reinvest in assets that will improve the bottom line.
Improving production efficiency:
Are you using your assets efficiently? Are some assets underused because there are bottlenecks elsewhere in the production process? Is there downtime in your production process that could be eliminated? Output, as reflected in your sales revenue, should increase significantly if your assets are used to their maximum capacity, without any material increase in your other expenses.
Leased, as opposed to owned, equipment is not counted as fixed assets on your balance sheet. Therefore, it does not feature in the asset turnover ratio.
Focusing on accounts receivable:
Slow collections will reduce the net sales on your income statement, thus reducing the asset turnover ratio. You can improve your invoice collection by outsourcing your collections to a debt collection service or reducing your payment terms, so customers have a shorter window in which to pay.
Improve your inventory control:
Finished goods that sit in the warehouse will not feature in your net sales, so your asset turnover ratio will be higher than it should be. The solution, in this case, is to think about how you can ship your product much faster and collect payment. Could you improve your delivery processes? Would investing in technology to automate your ordering and inventory control improve your inventory management?
What is the Asset Turnover Ratio Vs. ROA?
For small businesses, the most commonly used measure of profitability is the return on assets or ROA. Return on assets is similar to the asset turnover ratio, but it measures how well you are using your assets to generate profit, not just sales. To calculate ROA, divide your Net Income by Average Total Assets as follows:
ROA = Net income/ Average total assets
Net Income appears on the company's income statement. It shows the amount earned by the business after subtracting the expenses incurred, including taxes and depreciation. Average Total Assets is found on a company's balance sheet – it's the same number you plugged into the asset turnover ratio.
ROA shows the direct relationship between profit and the total assets of the company. The significance is that, by using net income instead of revenues, you're including expenses in the asset formula. As with asset turnover, the higher the ROA, the better. Few businesses perform well over time without achieving a decent percentage in this key indicator.
Can You Calculate the ROA Using the Asset Turnover Ratio?
It's also possible to calculate ROA using the asset turnover ratio, by using the following formula:
ROA = Net profit margin x Asset turnover ratio
Here, you are multiplying asset turnover (Net Sales Revenue divided by Average Total Assets) by Net Profit Margin (Net Income divided by Net Sales Revenue). The revenue cancels itself out, so what you're getting is Net Income divided by Average Total Assets – in other words, return on assets.
What's the significance? Remember, ROA is a profitability ratio. It measures the margin of profit for the amount invested in assets. Assets turnover, on the other hand, is an activity ratio. It measures how well you are generating revenue based on your usage of those assets. While the two ratios are subtly different, it is helpful to have both indicators when weighing up a company's management.
Here's an example. Suppose Company A achieves an 8-percent ROA with an asset turnover of 2.5 percent and a net profit margin of 3.5 percent. Company B's ROA is 6 percent, stemming from an asset turnover of 1.85 percent and a net profit margin of 5 percent. While Company B can boast a higher profit margin, Company A is using its assets much more efficiently, as can be seen by an asset turnover and ROA that's around 30-percent higher than Company B's.
What's happening here is symptomatic of a general trend – that companies with low asset turnover tend to have high-profit margins, and those with high asset turnover tend to have lower profit margins. The challenge for high-asset-turnover, low-profit-margin companies like Company A, is to maintain a good ROA because generally a low profit margin will lead to a low ROA unless the company is efficient.