Asset formula

What is asset rotation? | The Motley Fool

Asset turnover, also known as the asset turnover ratio, measures how effectively a company uses its assets to generate sales. It’s a simple ratio of net income to average total assets, and it’s usually calculated on an annual basis. Investors can use the ratio to compare two companies in the same industry and determine if one is better at allocating capital to drive sales.

This article will teach you how to calculate asset turnover, how to use it to make better investment decisions, and where it fails to provide analysis.

Asset rotation formula

The formula for calculating asset turnover is very simple:

Asset turnover = Total sales ÷ Average total assets

Average total assets are the average of the assets on the company’s balance sheet at the beginning of the period and at the end of the period. Companies usually declare their balance sheets also showing the balances of items from the previous year. This makes the calculation easier. You simply add the total assets reported at the end of the most recent period and the total assets at the end of the previous year. Divide the number by two to get the average assets.

Total sales, or revenue, are found on the business’s income statement. You may need to add up the sales for each individual quarter of the past year, or the company may provide annual sales.

Once you have numbers for total sales and average assets, divide the former by the latter to get the asset turnover rate.

Image source: Getty Images.

What does the asset turnover ratio tell you?

Calculating the asset turnover rate for a single company at a given time is not very helpful. The metric is most useful when benchmarked against competing companies in the industry or when tracked over time.

In general, a higher asset turnover rate is better. A business that generates more revenue from its assets operates more efficiently than its competitors and makes good use of its capital. A low asset turnover rate suggests that the company holds excess production capacity or has poor inventory management.

If a company shows an increase in asset turnover over time, it indicates that management is indeed scaling the company and increasing its productive capacity. This may be the case for growth stocks, which invest heavily in certain areas in the hope that income will rise to take advantage of its capital investments.

Investors can use the asset turnover rate to help identify important competitive advantages. If a company has a higher asset turnover rate than its peers, take the time to understand why this might be the case.

That said, if a company’s asset turnover is extremely high compared to its peers, that may not be a good sign. It may indicate that the management is not able to invest enough to boost the business to its full potential. Spending more by investing in more income-generating assets may reduce asset turnover, but it could provide a positive return on investment for shareholders. Management should strive to maximize profits even if the next investment is not as profitable as the previous one.

What is a good asset turnover rate?

A good asset turnover rate will vary from industry to industry. Some industries are very asset-heavy, while others are asset-light.

A retailer whose primary assets are typically inventory will have a high asset turnover rate. Its only purpose is to hand over assets. A software manufacturer, which may not have a lot of assets, will also have a high asset turnover rate. But a machine manufacturer will have a very low asset turnover rate because they have to invest heavily in machine manufacturing equipment.

This is why it is important to compare asset turnover between companies in the same industry. In retail, a good asset turnover may be around 2.5, but investors in utility stocks should generally not expect an asset turnover ratio above 0.5.

Example of using asset turnover rate

Let’s take a look at two of the biggest retailers in the United States: walmart (NYSE: WMT) and Target (NYSE: TGT). Both are big-box retailers trying to provide one-stop shopping for most of the country. Both also show significant strength in e-commerce.

Here are the important inputs for calculating asset turnover ratios for Walmart and Target over the past two years. (Note that Walmart’s 2022 fiscal year matches Target’s 2021 fiscal year.)

Company (fiscal year)

Walmart (2022)

Walmart (2021)

Target (2021)

Target (2020)

Starting assets

$252,496

$236,495

$51,248

$42,779

End assets

$244,860

$252,496

$53,811

$51,248

Average asset

$248,678

$244,496

$52,530

$47,014

Income

$572,754

$559,151

$106,005

$93,561

Asset turnover

2h30

2.29

2.02

1.99

All dollar figures are in millions. Data source: Walmart and Target.

Comparing the two big-box retailers shows that Walmart produces a significantly higher asset turnover rate. Target saw its asset rotation improve further over the prior year. For the most part, however, both companies kept asset turnover stable.

As such, the numbers indicate that Walmart has higher sell-through rates on its inventory and is making better use of its assets. Indeed, Walmart has done well to expand its curbside pickup and delivery service for online orders, which has led to greater usage of its stores. However, Target isn’t too far behind, especially when it comes to shipping packages to customers from its stores.

Asset turnover rate limits

Asset turnover rate doesn’t tell you everything you need to know about a company. Importantly, its focus on net sales means it eschews the profitability of those sales. As such, asset turnover can best be used in conjunction with profitability ratios.

Calculating return on assets, for example, can help an investor better understand the value of asset rotation from a profitability perspective. Additionally, using asset turnover as part of a DuPont analysis that calculates return on equity could provide additional insight into how a company generates shareholder profits.

It should also be noted that the asset turnover rate can provide bad information without additional context. For example, a company that invests heavily in anticipation of rapid growth in the future may show a decline in asset turnover. Similarly, a company that is liquidating assets in anticipation of a revenue slowdown would experience a spike in asset turnover.

Additionally, a company with excess cash on its balance sheet will show a low asset turnover rate compared to companies in the same industry with limited cash. Investors may be able to adjust to excess cash, but there is no clear line between the amount of cash needed for day-to-day operations and excess cash amounts.

The bottom line

Knowing how to calculate asset turnover and how to use it to identify companies with competitive advantages can help uncover good investment opportunities. At its most basic, asset turnover is a measure of management’s ability to use its capital efficiently. The higher the ratio, the better the work management.

But beware of taking the number at face value. Always dive deeper and determine why the asset ratio is where it is for each company you analyze. Examine the trends and how the company compares to other companies in the industry. Doing a little research can lead to solid returns on investment.


Source link