Asset turnover ratio is defined as the ratio between a company’s sales to its assets. It acts as an indicator of a company’s efficiency in deploying available assets to generate revenues. Asset turnover ratio is therefore considered to be an important determinant of a company’s performance.
The higher an asset turnover ratio, the better a company’s performance is considered to be. Asset turnover ratio can differ across companies. It is generally calculated annually for a specific financial year.
How to calculate Asset Turnover ratio and its interpretation?
The asset turnover ratio is one of the efficiency ratios used while analysing a company. It measures a company’s ability to generate sales using its assets. This ratio compares a company’s net sales to average total assets, thus enabling investors and creditors to determine how efficiently a company is using its assets to generate sales.
The total asset turnover ratio estimates net sales as a percentage of total assets. This shows the number of sales generated from every rupee of company assets.
Formula for Asset Turnover Ratio
The asset turnover ratio is calculated as –
Net sales / Average total assets
- Net sales – This can be found in a company’s income statement. It is important to take off sales refunds from total sales to get the true measure of a firm’s assets’ capability to generate sales.
- Average total assets – These can be calculated by adding together:
- the beginning and
- ending total asset balances
The final value must be divided by two to get average total assets.
Example of asset turnover ratio calculation
XYZ Tech Co. is a technology start-up in the business of manufacturing new tablet computers. The company is currently on the lookout for new investors. During a meeting with the company, the investors want to know how well it can use its assets to produce sales.
Upon requesting for the company’s financial statements, here is what was found:
Beginning assets: Rs 40,00,000
Ending assets: Rs 10,00,000
Net Sales: Rs 25,00,000
The asset turnover ratio will therefore be –
A ratio of 0.5 means that every rupee of XYZ company’s assets are able to generate Re. 0.5 of sales.
Interpreting asset turnover ratio
- Higher asset turnover ratio means that the company is able to use its assets more efficiently.
- Lower ratio means that the company is currently not using its assets most efficiently.
Why is it important to analyse asset turnover ratio?
A higher asset turnover ratio is always favourable since
- It reflects a company’s efficiency in utilising its assets for generating revenues.
- It indicates that the company is able to better utilise its assets.
Lower ratios are an indication that the company is unable to make the best use of its available resources and may likely have internal issues.
It is important to note that a company’s asset turnover ratio can be impacted by:
- Large asset sales
- Considerable asset purchases within a given year
The asset turnover ratio is very important for investors in comparing companies within the same sector or group. Comparing a retail company’s asset turnover ratio to that of a telecom firm may not be of use, since this ratio could vary across business segments. To make meaningful comparisons, investors must compare asset turnover ratios of different companies within the same sector.
Benefits of using asset turnover ratio
Here are some of the key benefits of using an asset turnover ratio while evaluating a company:
- Consider all the assets: Some of the other ratios like fixed asset turnover ratio only consider fixed assets, however, ATR considers all the assets being used by the company, i.e. both fixed and current assets.
- Reflects balance between revenue from sales and asset proportion: This ratio should especially be used by investors evaluating companies that are in the growth stage. It can help in checking if the revenues being generated are proportionate to the assets being deployed.
- Asset rating: With this ratio, company managers can also determine how effective or efficient the current assets under deployment have been for the company. They can categorise assets based on this rating and plan accordingly for the future.
What are the limitations of asset turnover ratio?
Some of the aspects to be noted while using asset turnover ratio are:
- Asset turnover ratio should ideally be compared between companies in the same industry. This is because the capital investment could vary significantly across different sectors.
- Investors should be careful while using it since some companies may artificially inflate the ATR by selling assets within the short term.
- This ratio can also be artificially deflated through large-scale investments in assets to show positive performance in the short-term.
Asset Turnover ratio is an important measure to analyse the capability of a company in utilizing its assets for generating revenues. It helps investors go beyond a good business plan and good earnings of a company to carefully analyse it’s inner ability. ATR can be a good tool for long-term investors, especially those who are looking to fetch larger value from their investment.
Efficiency ratios measure a company’s capabilities in using its resources for maximizing earnings. These are often used by investors as part of fundamental analysis.
Efficiency ratios are used by investors while evaluating companies for potential investments, as it can help them in making the right choice. Using this, investors can select companies that have a strong financial health and reflect higher potential for growth.
Some of the commonly used efficiency ratios include inventory turnover ratio, asset turnover ratio, accounts payable ratio, and accounts receivable ratio.
Ratio analysis is mostly based on past or historical information and is therefore not reflective of the current state. It may not consider external factors such as economic uncertainties, and also eliminates consideration of human elements within a company.
Ratio analysis is a management tool that aims to improve the understanding around financial results of a company and its trends. It offers key highlights of organizational performance. It can be used to identify strengths and weaknesses to further form strategies and initiatives.