Asset formula

Asset turnover ratio: explanation and formula

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The success of any business is largely based on its ability to effectively use its assets to generate sales. The asset turnover ratio measures how effectively a company uses its assets to generate sales by comparing the value of its sales to the average value of its assets.

Generally, companies with a high asset turnover rate are more efficient at generating revenue from their assets, unlike those with a low rate. The asset turnover rate can be a useful point of comparison for investors to assess the operations of different companies and their potential as an investment.

What is the asset turnover ratio

Businesses rely on their working capital to generate sales revenue. Working capital includes a company’s cash flow as well as its assets. Asset turnover rate is a financial measure of how efficiently a company uses its assets to generate sales revenue.

Companies that do not rely heavily on their assets to generate revenue have a higher asset turnover rate than companies that do. They tend to perform better because they use less equity and debt to generate revenue, which translates to more revenue generated per dollar of assets. For investors, this can mean a better return on equity. Companies with low asset turnover rates may rely too heavily on equity and debt to generate revenue, which can hurt their performance and long-term growth potential.

Key takeaway: Companies with higher asset turnover rates tend to perform better because they use less equity and debt to generate revenue.

The asset turnover ratio can be used to compare the performance of competing companies within the same industry to determine which are generating the most revenue for their dollar of assets. Seeking Alpha’s Peer Comparison tool (below) compares the asset turnover rates of competing companies (under the Peers > Profitability subset for each company):

Premium subscribers also have access to the Profitability Ratings feature under Seeking Alpha’s Quant Ratings tool, where they can see how a company ranks in terms of asset turnover rate against its industry and how well the ratio asset turnover is different from the industry median and its own 5-year average.

This could be particularly useful for analyzing companies in industries that typically have large asset bases.

Formula and Calculation of Asset Turnover Ratio

The formula for calculating the asset turnover rate is made up of two factors: a company’s net sales, which are its gross sales after accounting for returns, discounts and allowances; and its total assets, which is the total of its equity and liabilities at the beginning of the year plus the total at the end of the year divided by two. The formula is expressed as follows:

Asset Turnover = Net Sales / Total Assets

The components of the formula (net sales and total assets) are found in a company’s financial statements. To determine the value of net sales for the year, look at the company’s income statement for total sales. It could also be counted as income. The figure should be net of discounts, allowances and returns.

To determine the average value of the company’s assets for the year:

  1. Look at its balance sheet for the value of its assets at the start of the year.
  2. Find the value of the company’s assets at the end of the year.
  3. After adding the start value to the end value, divide the sum by two to reveal the average asset value, or total assets, for the year.

Total assets become the denominator of the asset turnover rate.

Example of Asset Turnover Ratio

As an example of how the asset turnover ratio is applied, consider the net sales and total assets of two fictitious retail businesses.

Company X

Company Y

Net Sales (Revenue)

$460,000,000

$70,000,000

Starting assets

$200,000,000

$40,000,000

End assets

$195,000,000

$39,000,000

Average total assets

$197,500,000

$39,500,000

Asset turnover rate

2.33

1.77

The asset turnover ratios of these two distribution companies allow a direct comparison of their performance. Company X generated $2.33 in sales per dollar of assets, while Company Y generated $1.77. This shows that Company X is more efficient in its use of assets to generate revenue. The lower ratio for Company Y may indicate slow sales or too stale inventory. It could also be the result of assets, such as property or equipment, not being used to their optimum capacity.

It is important to note that comparisons of asset turnover ratios are only meaningful for evaluating companies in the same sector or industry. There is no particular number that constitutes a good or a bad ratio. Ratios can vary significantly from industry to industry. Some sectors, such as retail and consumer staples, tend to have smaller asset bases with high sales volume, leading to higher ratios as they need to replace their inventory at a high rate every year.

Conversely, telecommunications and utility companies have large asset bases that turn over more slowly relative to their sales volume. Thus, comparing the asset turnover rate between a retail company and a telecommunications company would not make sense. However, examining the ratios of two telecommunications companies would be a productive comparison.

Companies in the services industry, such as financial services companies, typically have smaller asset bases or a greater reliance on intangibles, which makes the ratio less meaningful as a comparison tool.

Important: Asset turnover rate should only be used to compare similar companies within the same industry or sector.

Understanding the Asset Turnover Ratio

One of the most important considerations for investors when evaluating a company is how efficiently it uses its assets to generate income. Typically, capital-intensive companies with a high asset turnover rate have the ability to operate on fewer assets than their less efficient competitors who might rely heavily on their equity and debt to operate. These companies have greater potential for growth and growth in profits over time.

However, experienced investors avoid relying on a single reading of the one-year ratio because it can fluctuate. Or it can be affected by one-time events, such as when a company deliberately increases its inventory to meet a large, single customer order or sells a large portion of its inventory in a short period of time. For this reason, investors should examine the ratio’s trend over time.

Also, a high turnover rate does not necessarily translate into profits, which is a more accurate way to measure a company’s performance. For example, companies that outsource much of their production may have much higher revenue but less profit than their competitors.

In-depth analysis considers asset turnover rate in conjunction with other metrics, such as return on assets, for a clearer picture of a company’s performance.

Asset turnover ratio to fixed asset turnover

Asset management ratios such as asset turnover rate are essential in analyzing how a company manages its assets to generate revenue. Some investors or analysts are more concerned with how a company manages its fixed assets and how efficiently they are used to generate sales revenue. While the asset turnover ratio looks at a company’s total assets, the fixed asset ratio only considers its fixed assets. Fixed assets include property, plant and equipment as shown on the balance sheet, less accumulated depreciation.

Although the fixed asset ratio is also a measure of the efficiency of a company’s operational performance, it is more widely used in manufacturing companies that are highly dependent on plant and equipment. Like the asset turnover ratio, the fixed asset turnover ratio measures operational efficiency, but it is less likely to fluctuate because the value of fixed assets tends to be more static. Companies with a high fixed asset ratio tend to be well-run businesses that use their capital investments more effectively to generate sales.

Key point to remember: Although the asset turnover and fixed asset turnover ratios are similar, the fixed asset ratio is more meaningful for companies with significant investments in fixed assets.

Conclusion

Investors can use the asset turnover ratio to measure how efficiently a company uses its assets to generate sales revenue. A higher asset turnover rate implies that a company generates a higher level of revenue per dollar invested in its assets. The ratio can then be used to compare a company with its competitors within the same industry.


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