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What is Asset Turnover Ratio & How is it Calculated?

What is Asset Turnover Ratio & How is it Calculated?
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Asset Turnover Ratio is a fundamental metric that plays a crucial role in assessing a company’s operational efficiency and overall financial health. It measures how effectively a company utilizes its assets to generate sales revenue. Wondering how Asset Turnover Ratio works? Let’s understand.

What is Asset Turnover Ratio?

The Asset Turnover Ratio evaluates how a company utilizes its assets to generate revenue or sales. It does so by comparing the rupee amount of sales or revenues to the total assets of the company. This financial ratio provides valuable insights into how effectively the company’s operations utilize its assets to drive its revenue generation.

A higher ATR generally suggests that the company is using its assets efficiently to generate sales, while a lower ratio may indicate inefficiency in asset utilization. 

However, there are two variants of the asset turnover ratio: net asset turnover ratio, which considers only net assets (total assets minus total liabilities), and fixed asset turnover ratio. Therefore, monitoring both variants is crucial for businesses as it helps in assessing and identifying opportunities to improve asset utilization. Now that we know what Asset Turnover Ratio Means, let’s see how is the Asset Turnover Ratio calculated!

What Does Asset Turnover Ratio Measure?

The asset turnover ratio gauges a company’s asset efficiency in generating revenue, comparing sales to total assets annually. To calculate it, divide net sales or revenue by the average total assets. A variation, the Fixed Asset Turnover (FAT) ratio, considers only a company’s fixed assets.

How to Calculate ATR?

Calculating the asset turnover ratio is relatively straightforward. To do so, divide the company’s net sales (or total revenue) by its average total assets formula during a specific period. 

Formula for Asset Turnover Ratio

The Asset Turnover formula is as follows:

Asset Turnover Ratio = Net Sales / Average Total Assets

where, 

Total sales = Annual sales total 

Beginning Assets = Assets at the start of the year

Ending Assets = Assets at the end of the year

To compute the ratio, find the net sales and calculate the average total assets by adding the beginning and ending total assets for the period and dividing the sum by two.

Example of How to Use the Asset Turnover Ratio

Year Beginning Assets Ending Assets Avg Total AssetsRevenue Total Asset Turnover
20195,00,0006,00,000 5,50,0002,000,0003.64  
20206,00,0007,00,000 6,50,0002,500,000 3.85 
20217,00,0008,00,000 7,50,0003,000,0004.00

Using the provided data, the Asset Turnover Ratio can be calculated for each year as follows:

  • For the year 2019:

Revenue = Rs. 2,000,000

Average Total Assets = (Beginning Assets + Ending Assets) / 2 = (Rs. 500,000 + Rs. 600,000) / 2 = Rs. 550,000

Asset Turnover Ratio for 2019 = Rs. 2,000,000 / Rs. 550,000 = 3.64 times

  • For the year 2020:

Revenue = Rs. 2,500,000

Average Total Assets = (Beginning Assets + Ending Assets) / 2 = (Rs. 600,000 + Rs. 700,000) / 2 = Rs. 650,000

Asset Turnover Ratio for 2020 = Rs. 2,500,000 / Rs. 650,000 = 3.85 times

  • For the year 2021:

Revenue = Rs. 3,000,000

Average Total Assets = (Beginning Assets + Ending Assets) / 2 = (Rs. 700,000 + Rs. 800,000) / 2 = Rs. 750,000

Asset Turnover Ratio for 2021 = Rs. 3,000,000 / Rs. 750,000 = 4.00 times

So, according to the Total Asset Turnover Ratio formula, the ratio for each year is as follows:

  • 2019: 3.64 times
  • 2020: 3.85 times
  • 2021: 4.00 times

Interpretation of Total Asset Turnover Ratio

The total asset turnover formula ratio measures a company’s ability to generate revenue or sales in relation to its total assets. It uses the Total Assets Formula. A higher ratio indicates that the company is utilizing its assets efficiently to generate sales, which is generally seen as a positive sign.

On the other hand, a lower total assets turnover formula ratio may indicate that the company is not effectively utilizing its assets to generate sales, which could be a cause for concern. 

If the ATR < 1

  • If the asset turnover ratio is below 1, it signifies that the company’s total assets are not efficiently generating enough revenue, which may not be favorable for its performance.
  • However, this judgment depends on the industry’s typical asset turnover ratio. If the industry average generally falls below 0.5, and the company’s ratio is 0.9, it can be considered as performing well despite having a lower asset turnover compared to the industry average.

If the ATR > 1

  • On the other hand, an asset turnover ratio above 1 is generally seen as positive, indicating the company’s ability to generate ample revenue from its total assets. Nonetheless, exceptions can arise. 
  • For instance, in a retail industry where companies intentionally maintain low total assets, leading to an industry average ratio over 2, if a company has an asset turnover ratio of 1.5, it may not be performing well. In such a scenario, the company’s owner should contemplate restructuring to enhance revenue generation.

Using the Asset Turnover Ratio With DuPont Analysis

DuPont Analysis breaks down the return on equity (ROE) into three components: profit margin, asset turnover, and financial leverage. Asset turnover is a key component of this analysis, and it can be further divided into fixed asset turnover ratio and current asset turnover ratio.

The fixed asset ratio formula focuses on how efficiently a company utilizes its fixed assets, such as real estate, plant, and equipment, to generate sales turnover ratio revenue. A higher fixed asset turnover ratio indicates effective utilization of these long-term assets, which can lead to improved profitability. On the other hand, the current asset turnover ratio assesses how well a company employs its current assets, like cash, inventory, and accounts receivable, to generate sales. 

Lastly, by combining the asset turnover ratio with DuPont analysis, investors and analysts can gain a comprehensive understanding of a company’s financial performance. Also, pinpoint areas of operational efficiency or inefficiency, and make informed decisions. 

Difference Between Net Asset Turnover Ratio and Fixed Asset Turnover Ratio

The Net Asset Turnover Ratio and Fixed Asset Turnover Ratio are both financial metrics used to assess a company’s efficiency in utilizing its assets to generate sales revenue. However, they differ in terms of the assets they consider and the insights they provide:

Net ATR

The Net Asset Turnover Ratio measures how effectively a company generates sales from its net assets. Net assets refer to total assets minus total liabilities, representing the shareholders’ equity or the portion of assets owned by shareholders. This ratio provides a broader view of asset utilization since it considers both fixed assets and current assets. Now let us look at how Net Capital Turnover Ratio is calculated. 

Net Capital Turnover Ratio Formula can be expressed as:

Net Asset Turnover Ratio = Net Sales / Average Net Assets

Fixed ATR

The Fixed Asset Turnover Ratio specifically focuses on how efficiently a company uses its fixed assets, such as property, plant, and equipment, to generate sales. It provides insights into the effectiveness of long-term asset utilization in revenue generation.
Fixed Assets Turnover Ratio formula can be expressed as:

Fixed Asset Turnover Ratio formula can be expressed as: Net Sales / Average Fixed Assets

How can Companies Improve their Asset Turnover Ratios?

Companies can enhance their asset ratio through several strategies, including:

  1. Increasing their revenue
  2. Enhancing inventory management
  3. Selling their assets
  4. Opting for asset leasing over outright purchases
  5. Expedited collection of accounts receivables
  6. Improving overall operational efficiency
  7. Implementing computerized inventory and order systems

Efficient management of fixed assets and resources is crucial for businesses to maintain optimal operational infrastructure, ensure regulatory compliance, and minimize disruptions and financial losses due to avoidable downtimes. Therefore, internal maintenance management must focus on cost control, efficient work scheduling, and confirming adherence to regulations.

What are the Limitations of the Asset Turnover Ratio?

Here are some of the limitations of the asset turnover ratio:

  • Disregards Asset Quality: It overlooks the quality of a company’s assets. Companies with older, outdated assets may show a lower turnover ratio compared to those with newer, more efficient assets. 
  • Ignore Industry Differences: This can vary significantly between industries. For instance, a retail company may exhibit a higher ratio than a manufacturing company due to industry-specific operational dynamics.
  • Inadequate Measure of Profitability: While it assesses asset utilization, it fails to consider a company’s profitability. A company with a high asset turnover ratio might still incur losses if its operating costs are excessive.
  • Vulnerable to Manipulation: It can be manipulated by company management. For example, a company may sell off assets to artificially improve its asset turnover ratio, providing a misleading impression of operational efficiency.

To Wrap It Up…

The asset turnover ratio is a financial metric that measures the relationship between revenues and assets. A higher ATR signifies a company’s exceptional ability to generate significant revenue using a relatively smaller pool of assets. For optimal use, it is best employed for comparing companies within the same industry, providing valuable insights into their operational efficiency and revenue generation capabilities.

FAQs

1. What is the Asset Turnover Ratio formula?

The Asset Turnover formula is as follows: Net Sales / Average Total Assets

2. What are asset turnover and current assets turnover ratio?

Asset turnover is a measure of how efficiently a company uses its assets to generate sales. Whereas, the current ratio is a measure of a company’s ability to pay its short-term debts.

3. How to improve the asset turnover ratio?

To improve a low ATR, a company can take measures like stocking popular items, restocking inventory when needed, and extending operating hours to attract more customers and boost sales.

4. Is asset turnover a profitability ratio?

Asset turnover is not primarily a measure of profitability. Instead, it gauges how efficiently a company utilizes its assets to generate sales.

5.  What is a good asset turnover ratio?

Asset turnover ratios differ between industry sectors, making it crucial to compare only companies within the same sector. For instance, retail or service sector companies typically have smaller asset bases but generate higher sales volumes, resulting in higher average asset turnover ratios.

6. What is the asset turnover ratio vs. return on assets?

The asset turnover ratio assesses a company’s efficiency in using assets for sales generation, while return on assets (ROA) gauges its efficiency in generating profits with assets. ATR focuses on operational efficiency, whereas ROA encompasses both operational efficiency and profitability.