Asset Turnover Ratio: Meaning, Formula and How to Calculate
Asset turnover ratio is the ratio between the company’s net sales and the value of its assets. It is calculated annually and is a major indicator of the efficiency of a company based on how well it uses its assets to generate revenue from its operations.
Let’s dive in to know more about asset turnover ratio, its importance in business and how is it calculated..
What is Asset Turnover Ratio?
It is a metric that’s used to analyse an organisation’s financial standing and is usually calculated annually. It indicates how well a company uses its assets to generate revenue. It is classified as an efficiency ratio, marking the efficiency with which a company can increase its net sales revenue by employing its resources.
It is a useful tool for stakeholders like investors and creditors to analyse a company’s performance. By comparing the asset turnover ratio (ATR) of different companies in the same sector, they can analyse which company is performing better and making the most of its owned assets. It’s safe to say that a company with a high ATR has a good performance rate.
How to Calculate Asset Turnover Ratio?
The asset turnover ratio is the ratio between the net sales of a company and the average of its total assets. You can calculate it using the formula formula:
Asset turnover ratio = net sales revenue / average total assets
Here, Net sales revenue = revenue from sales – sales returns – discounts and allowances
Average total assets = (assets at the beginning of the year + assets at the end of the year) / 2
Let us understand the total asset turnover ratio formula better with the help of an example.
Company Y held assets worth Rs.50 lakh at the beginning of the year. During the year, the revenue from sales amounted to Rs.35 lakh. However, there were also Rs. 5 lakh sales returns during the year. At the end of the financial year, the balance sheet of Company Y reflected total assets worth Rs. 54 lakh.
The ATR of Company Y will be calculated as:
Net sales revenue = revenue from sales – sales returns
= 35,00,000 – 5,00,000
= 30,00,000
Average total assets = (assets at the beginning of the year + assets at the end of the year) / 2
= (50,00,000 + 54,00,000) / 2
= 52,00,000
Asset turnover ratio = net sales revenue / average total assets
= 30,00,000 / 52,00,000
= 0.58
Let us now understand how this resulting ratio is interpreted.
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How to Interpret Asset Turnover Ratio?
An asset turnover ratio of over 1 is always considered good. A high ratio means the company is earning more revenue by fully utilising its assets. This implies that the company is generating enough net sales revenue by employing its own resources. A lower ratio indicates that the assets are not efficiently used to generate revenue. This can signify poor management, bad inventory control, production issues, etc.
However, analysts do not take this ratio at its face value. It is mostly used for comparison between different companies. Moreover, the ATR trend varies from industry to industry.
For instance, an ATR approximately 2.5 is considered good in the retail sector. At the same time, in the utility industry, a ratio of 0.25 is satisfactory. Thus, two companies can be compared based on this metric only if they belong to the same sector.
Moreover, an asset turnover analysis can be conducted by plotting a graph of a company’s performance (as per the ratio) over a few years. An upward trend in the graph is a good sign of growth, as it indicates that the company is gradually improving its efficiency and utilising its assets better.
If the graph moves downwards, it signals the management to change their plans and policies to counter this trend.
How to Improve Asset Turnover Ratio?
Companies can improve their asset turnover in the following ways:
- Increases sales revenue by improving production and inventory management
- By leasing assets, the number of owned assets decreases, increasing the ATR
- By outsourcing the production process. With this, the companies are required to hold fewer assets. At the same time, this keeps the sales constant
- By improving overall efficiency. This can be done by using new technologies and computer systems, reducing human error and the time taken to complete tasks
What is a Good Asset Turnover Ratio?
A good asset turnover ratio is when it is above 1, since it implies that the company is fully utilising its owned resources to generate sales revenue. The higher the ratio, the better. It means that the company is earning more revenue by using its resources best. However, a ratio lower than 1 can be a sign of concern, as it indicates that the assets are not being efficiently used to build revenue. But, this differs from one sector to another, and a comparative analysis must be done to draw accurate conclusions.
Asset Turnover Ratio vs. Fixed Asset Turnover
As we have seen, the ATR is calculated by measuring and keeping the average total assets of the company in the denominator. This includes the average of all the assets, including fixed and current assets of the company. This ratio indicates the overall efficiency of the company.
On the contrary, the fixed asset turnover uses the value of the fixed assets in the denominator. Fixed assets include the firm’s long-term assets, such as plant, machinery, furniture, equipment, etc. Because of this, the ratio indicates the operating performance of the company.
The formula is:
Fixed asset turnover ratio = net sales revenue / average fixed assets
Where to Find and Compare Asset Turnover Ratios?
You can calculate it using the formula given above. If you don’t want to make calculations manually, you can use an online calculator for the same. The figures to be put in are easily available on the company’s balance sheet.
There are also many online platforms that facilitate comparing the ATRs of different companies. Select the companies or a particular sector, and the details for the same will be displayed.
Also Read: Acid Test Ratio: Meaning, Formula and Calculation
Limitations of Asset Turnover Ratio
The asset turnover ratio suffers from the following limitations:
1. New purchases can bring down the ratio
A new purchase of a large asset can temporarily bring down the ratio to the sudden significant increase in the value of assets. The purchase may be due to a growth opportunity, but the contrary may be reflected due to a falling ratio. Similarly, when there is a decline in the growth of a company, it may start selling its assets. The reduced assets can bring up the ratio, however, it is not a good thing here.
2. Impact of outsourcing
In case the production is outsourced, the company would not need a lot of assets to continue its business operations. This will increase the ratio even when there is not much revenue, giving an edge to the company over its competitors.
3. Not the perfect yardstick
The turnover ratio of assets cannot be viewed individually to deduce the profitability of a company. It must be compared with other companies of the same industry or with the company’s past performance.
Final Word
The asset turnover ratio is calculated by dividing the net sales revenue by the average total assets of the company. It shows how efficiently the company is using its assets to generate revenue from sales. This metric is helpful in comparing the performance of different companies. It also helps the management find places of improvement in terms of workers efficiency and inventory control.
FAQs on Asset Turnover Ratio
Ans. It is the ratio between the net sales of a company and the average of its total assets. It is used to calculate the efficiency of a firm.
Ans. You can use the following formula:
Asset turnover ratio = net sales revenue / average total assets
Ans. The ATR is calculated by measuring and keeping the average total assets of the company in the denominator. This includes the average of all the assets, including fixed and current assets of the company. Whereas, the fixed ATR uses the value of only the fixed assets in the denominator.
Ans. A good turnover ratio is when it is above 1, since it implies that the company is fully utilising its owned resources to generate sales revenue. However, the ideal ratio of every industry is different based on the nature of its operations.
Ans. You can calculate average total assets using the following formula:
Average total assets = (assets at the beginning of the year + assets at the end of the year) / 2
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
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