What is the Asset Turnover Ratio?
The asset turnover ratio, also known as the total asset turnover ratio, measures the efficiency with which a company uses its assets to generate 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 compared to competitors with lower ratios.
Asset Turnover Ratio Formula
The formula for the ratio is as follows:
- Net sales are the amount of revenue generated after deducting sales returns, sales discounts, and sales allowances.
- Average total assets are the average of aggregate assets at the end of the current year and preceding year. Note: an analyst may use either average or end-of-period assets.
Example of Asset Turnover Ratio
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 Asset Turnover 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.
Asset 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 asset turnover ratio 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. In such cases, 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 asset turnover ratio measures how efficiently a company is using assets to generate sales. Therefore, a higher ratio is favorable, as it indicates a more efficient use of assets. Conversely, a lower ratio indicates that the company is not using assets as efficiently as it might. This can be due to excess production capacity, poor collection methods, or poor inventory management.
It is important to compare the ratios between companies operating in the same industry, as the benchmark asset turnover ratio varies greatly depending on the industry. Industries with a low profit margins tend to generate a higher ratio and capital-intensive industries tend to report a lower ratio.
- The asset turnover ratio is an efficiency ratio that measures how efficiently a company is using its assets to generate sales.
- Comparing the asset turnover ratios of companies in different industries is not appropriate, as industries vary in capital intensiveness.
- A higher ratio, between companies in the same industry, is generally always favorable, as it indicates an efficient use of assets.
- A lower ratio, comparing companies in the same industry, indicates poor efficiency, which may be due to poor utilization of fixed assets, poor collection methods, or poor inventory management.
Video Explanation of Asset Turnover Ratio
Watch this short video to quickly understand the definition, formula and application of the asset turnover ratio.
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