Asset Turnover Ratio – What You Need To Know
Asset Turnover Ratio reveals the ability of a company to generate sales and revenue from its present assets.
When analyzing a company, there are plenty of metrics that you need to consider. While popular metrics such as net income, gross sales, assets, and liabilities are very useful, but most of the time these will only give you a broad overview. And, there are certain cases that nuggets of gems or catastrophic problems can hide under these metrics undetected. Its the reason why you should be acquainted with other metrics that give you a better picture of a company.
For example, a certain company is reporting good sales. However, you are a bit bothered by what is inside the asset tab. Specifically, you want to know how fat or efficient the company when it comes to making use of its assets. For such a scenario, the metric you are looking for is Asset Turnover Ratio.
In this article, you will learn about the asset turnover ratio, how it is calculated, and its importance.
Asset Turnover Ratio – What is It
Because of how the asset turnover ratio is calculated, it reveals the ability of a company to generate sales from its present assets. The core idea behind this specific ratio is dividing revenue with the total assets. From this calculation, you can gauge how efficient a company is making use of its assets to generate sales.
Typically, the total asset turnover ratio is shown in percentage form. From it, you can derive how much sales is a company is generating from each dollar of assets. For example, if a company is having a ratio of 0.50, then that means the company is generating 50 cents of sales for each dollar of asset.
Asset Turnover Ratio Formula
The formula for calculating the asset turnover ratio is very simple. Asset Turnover Ratio equation is:
Asset Turnover Ration = Net Sales / Average Total Assets
In most cases, the net sales that are under the income statement are what used to calculate for this ratio. It is also crucial that any refunds must be taken into consideration to ensure that you get a more accurate picture of the company’s ability to generate sales from its assets.
Asset Turnover Ratio Calculator
To obtain the average total assets, you simply add the ending and beginning total assets, and then divide the sum by two. This is just a simple way of averaging the assets when you are using two time periods. You can also make use of a weighted average if you feel you can get a more accurate picture. However, in most cases, it’s not mandatory.
Importance of Asset Turnover Ratio
As mentioned above, the asset turnover ratio is an excellent metric if you want to know how efficient a company is converting sales from its assets. Hence, the higher the ratio, the more efficient the company. On the other hand, if a company has a lower asset turnover ratio, it may mean that the company is having production or management problems.
Another use of the asset turnover ratio is when comparing several companies. Generally, the company with a higher ratio means it’s more efficient when it comes to making use of its assets.
However, be careful when comparing two or companies that do not belong to the same sector as the asset turnover ratio may not give you an accurate picture. For example, it’s not wise to compare the asset turnover ratio of an online store to a manufacturer. An online store requires little assets to produce good sales. On the other hand, a manufacturer has to buy assets that are needed to produce the goods for selling. They also require large storage warehouses. If you compare the two together, you may be tricked into thinking that the online store is more efficient than the manufacturer. In reality, even a badly managed online store will still likely have a higher ratio compared to a very efficient manufacturer.
In most cases, every sector has an industry standard when it comes to the asset turnover ratio. If you are evaluating several companies for your stock portfolio, you can simply check out the industry standard and use it to weed out the companies that don’t make the cut. In most cases, you will be left with fewer but more efficient companies.
For investors who would want to invest in a company, the asset turnover ratio is a metric that can help reveal hidden and major problems. For example, a company may boast having high sales. However, upon checking the asset turnover ratio, the company is below average. In such instances, it could be possible that the entrepreneur or the team may be fond of buying “assets” that do not help in increasing sales. Such a scenario is a big red flag for investors.
One Big Weakness Of Asset Turnover Ratio
Just like any other metric, the asset turnover ratio has its weaknesses. Hence, you should never blindly trust it. One big weakness of the said metric is it doesn’t take into account the future impact of research and development.
In most cases, items that are related to research and development are listed in assets. If a company is heavily invested in research and development, it will bloat the assets tab. Since the research and development don’t yet bring any sales, it will bring down the asset turnover ratio.
However, things could change drastically once research and development finishes, and new service or product shoot the sales upwards. If you blindly believe the asset turnover ratio, you’ll be thinking that it’s an inefficient company that’s not worth investing in. As a result, you just missed an excellent opportunity.
Wrapping It All Up
The asset turnover ratio is an important metric for gauging the efficiency of a business in terms of converting assets into sales. The formula is simple, which is dividing the net sales with the average total assets. Keep in mind that similar to all metrics, the asset turnover ratio has its downside. And, one big downside is it doesn’t take into account the possible result of research and development activities. Nevertheless, the asset turnover ratio should be an important part of due diligence for any investor or entrepreneur. As markets get competitive, companies that are efficient with their assets have a higher chance of success.