Financial ratios are a popular method of analysis used by both investors and management. When examining the total asset turnover ratio, it's important to understand what account balances and transactions are included in each number. Total assets include short term assets like cash, securities, accounts receivable and inventory along with long term assets like investments, machinery, buildings and land. Revenue includes all money earned from both operating and non-operating activities, less any sales returns and discounts.
Total asset turnover seeks to measure how efficiently a company uses assets to promote sales. It can help managers put a dollar figure on the productivity of their assets. To calculate asset turnover, divide revenue by average total assets. For example, a company with revenue of $10,000 and assets valued at $5,000 (10/5) has a turnover ratio of 2. The higher the ratio, the more efficiently the company is using their assets.
The primary advantage of the total asset turnover ratio is the same as any financial ratio; it puts company-specific asset information in a form that is easily comparable for investors. Managers can discover asset successes and failures by examining the ratio year over year. For example, if the asset turnover ratio suddenly drops, it could indicate that an asset has become obsolete to operations and should be sold.
Although the asset turnover ratio appears comparable across companies, investors must thoroughly understand company strategy before employing it. Companies within the same industries will show different asset turnover ratios depending on their profit margin. For example, a low-priced grocery store with high milk and bread sales will show a higher turnover ratio compared to a specialty grocery store. In this situation, the discrepancy in the ratio may have nothing to do with asset efficiency and everything to do with profit-volume strategy.
Differences in depreciation methods and inventory valuation can skew the results of the total asset turnover ratio. Two companies could potentially have the exact same set of assets, yet show different asset account balances on their balance sheet. In the U.S., managers can freely choose from a variety of inventory valuation methods that artificially inflate or deflate the value on the balance sheet. Similarly, managers can choose to depreciate their assets consistently over the life of the asset, or accelerate the depreciation for tax purposes.
When viewing assets in terms of revenues, users have the tendency to assume the two are interrelated. However, the asset turnover ratio only measures the correlation of the two values and does not indicate any causation. A drop in asset turnover ratio could lead managers on a wild goose chase for obsolete assets, when in reality the revenue dropped for an independent reason. Because of this pitfall, the asset turnover ratio should be analyzed alongside a variety of profit and revenue ratios.