The asset turnover ratio, also known as the total asset turnover ratio, measures the efficiency with which a company uses its assets to produce sales. The asset turnover ratio formula is equal to net sales divided by the total or average assets of a company. A company with a high asset turnover ratio operates more efficiently as compared to competitors with a lower ratio.
The asset turnover ratio measures is an efficiency ratio that measures how profitably a company uses its assets to produce sales.
Comparing the ratios of companies in different industries is not appropriate, as industries vary in capital intensiveness.
A higher ratio is generally favorable, as it indicates an efficient use of assets.
A lower ratio indicates poor efficiency, which may be due to poor utilization of fixed assets, poor collection methods, or poor inventory management.
Formula for Asset Turnover Ratio
The formula for the asset turnover ratio is as follows:
Net sales are the amount of revenue generated after deducting sales returns, sales discounts, and sales allowances.
Average total assets is the average of total assets at year-end of the current and preceding fiscal year. Note: an analyst may use either average or end-of-period assets.
Asset turnover ratio example
Company A reported beginning total assets of $199,500 and ending total assets of $199,203. Over the same period, the company generated sales of $325,300 with sales returns of $15,000.
The asset turnover ratio for Company A is calculated as follows:
Therefore, for every dollar in total assets, Company A generated $1.5565 in sales.
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Comparisons of Ratios
Consider four hypothetical companies: Company A, Company B, Company C, and Company D. Companies A and B operate in the fast-food industry, while companies C and D operate in the telecommunications industry:
The asset turnover ratio for each company is calculated as net sales divided by average total assets.
Ratio comparisons across markedly different industries do not provide a good insight into how well a company is doing. For example, it would be incorrect to compare the ratios of Company A to that of Company C, as they operate in different industries.
It is only appropriate to compare the asset turnover ratio of companies operating in the same industry. We can see that Company B operates more efficiently than Company A. This may indicate that Company A is experiencing poor sales or that its fixed assets are not being utilized to their full capacity.
Interpretation of the Asset Turnover Ratio
The ratio measures the efficiency of how well a company uses assets to produce sales. A higher ratio is favorable, as it indicates a more efficient use of assets. Conversely, a lower ratio indicates the company is not using its assets as efficiently. Obsolete inventory or sluggish sales can lower the ratio. Same with receivables – collections may take too long, and credit accounts may pile up. Fixed assets such as property, plant, and equipment (PP&E) could be unproductive instead of being used to their full capacity.
All of these categories should be closely managed to improve the asset turnover ratio.
The asset turnover ratio can vary greatly depending on the industry. Industries with low profit margins tend to generate a higher ratio and capital-intensive industries tend to report a lower ratio.
Video Explanation of Asset Turnover Ratio
Watch this short video to quickly understand the definition, formula, and application of this financial metric.
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