What Is Asset Turnover Ratio? (With Formula And Example)
Updated 5 December 2022
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The asset turnover ratio helps financial analysts, investors and companies understand the organisation's growth over a few years. It sets industry standards for performance and helps companies monitor their expenses and maximise revenue using their assets. Learning to calculate the asset turnover ratio helps make informed financial decisions. In this article, we discuss what is asset turnover ratio, understand how to calculate it, explore its benefits and find out some ways to improve it.
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What Is Asset Turnover Ratio?
Understanding the answer to "What is asset turnover ratio?" can help a company identify its assets to generate revenue. It is the assets that a company owns with a potential for current or future economic benefit. An asset turnover ratio is a ratio that determines how efficiently a company uses its assets to generate sales. It calculates the net sales as a percentage of the company assets, indicating the sales generated from the company assets.
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Importance Of Asset Turnover Ratio
The asset turnover ratio is essential to understand how a company can maximise its return on every investment. A higher ratio indicates the company is generating a high revenue on its investments. A positive year-on-year increase in the asset turnover ratio indicates the company gradually expands its capacity without generating losses.
Advantages Of Asset Turnover Ratio
Analysing the company's financial data to calculate the asset turnover ratio is highly beneficial. Some of the advantages of understanding and evaluating this ratio are:
Measure the company's performance
It is an indicator of how the company is performing. It also reflects how well the company manages its resources and uses them to increase profits. Financial analysts and investors use this ratio to determine their investment choices.
Sets industry standards
Each industry progresses at different rates and has varied requirements. Due to this, a standard asset turnover ratio across sectors may seem unfair. When multiple companies calculate this ratio, it helps set standards that the industry may follow. It also allows new and old companies to monitor their progress against their competitors.
Improve business decision making
Comprehending the asset turnover ratio helps the management regulate their expenses. They understand the returns on their assets and take calculated risks in their next purchase or expansion plans. It also enables businesses to explore new ways to generate an income using their current or fixed assets.
Related: What Is Decision Making? Definition, Types And Tips
Monitor asset impairment
When companies calculate the asset turnover ratio on a year-on-year basis, they monitor the revenue that an asset may lose due to depreciation. A sudden drop in the ratio may indicate that one or more assets are losing their ability to generate income. The company may then re-evaluate their finances and look for alternatives to maintain and improve its income through assets.
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Benefits For Investors
Companies that maintain a high asset turnover ratio may garner more investments. As an investor, this ratio helps evaluate a company against its competitors before making an investment decision. Some benefits of the asset turnover ratio to an investor include:
Comparing the year-on-year values within a company helps identify changes in its efficiency. It helps investors understand the progress made by a company over a few years. For example, a company with an average asset turnover ratio that has been gradually increasing in the past five years may seem like a good investment choice.
The asset turnover ratio helps investors determine the relative financial health of a company. They compare this ratio with direct competitors to understand the industry trends. It also helps them determine an efficient investment opportunity among several organisations in a given industry. Additionally, since the metric standards vary with industry, it offers an efficient and conclusive value to evaluate companies within the same sector.
Tips To Improve Asset Turnover Ratio
A higher asset turnover ratio means a company may attract greater investments and has higher net sales. There are several methods in which a company may improve their asset turnover ratio. Some methods include:
Boost net sales: Companies focus on improving their net sales by reducing production costs. It is also necessary for companies to widen their distribution network to reach more customers.
Minimise product return rate: It is especially applicable for companies that serve consumers. Reduce the logistical cost of returning shipments by setting up stringent methods to track frauds.
Widen the product range: Introduce more products that are scalable and have higher profit margins. Identify products to manufacture using the existing fixed assets, thereby opening new channels to generate revenue.
Replenish inventory only when necessary: Excess inventory may become a liability if not consumed within the right time. Restocking the inventory basis of customer demands and sales spikes may help improve inventory management.
Related: Assets And Liabilities: Differences, Types And Relationship
How To Calculate The Asset Turnover Ratio?
Understanding the asset turnover ratio of a company can help companies make informed investment decisions. Here are the steps to follow to calculate a company's asset turnover ratio:
1. Gather financial data
Gather the company's financial data, including details of the fixed assets, current assets and sales. Assessing the company's balance sheet may help companies collate the required information. Define the period or financial term to calculate the asset turnover ratio before gathering data. It is essential to collect updated and accurate financial records for precise calculation.
2. Calculate net sales
Collect the company's sales data for a defined period to calculate its net sales. The total sale value represents the gross sales of the company. Subtract the value of any returns, allowances or discounts that lowers the total income accrued. The obtained value after all deductions is the company's net sales.
Related: What Is Revenue? Definition, Types, Examples And More
3. Calculate the average asset value
Determine the company assets and their value at the start and end of the financial year or preferred period to calculate the asset turnover ratio. Companies may locate these values using their balance sheet. Add the beginning asset value to the ending value and divide the sum by two. The value obtained is the average asset value required for further calculation.
Average asset value = Asset value at the beginning of the year / Asset value at the end of the year
4. Calculate the asset turnover ratio
The asset turnover ratio compares the net sales to the average asset value. Divide the net sales by the average asset value. The resulting number is the asset turnover ratio.
Asset turnover ratio = Net sales / Average asset value
Related: Revenue Vs Turnover: Meaning, Key Differences And Examples
5. Compare the result to the industry standards and competitors
A high asset turnover ratio indicates that a company uses its resources efficiently, while a low value means that the company requires improvement. Assess the industry standards depending on the sector in which the company operates. An understanding of the industry standards can help determine how a company compares to its competitors.
6. Analyse the cause
After determining the asset turnover ratio with the industry standards, it is essential to understand the underlying reasons behind the value. Identify the factors that led to a high or low value. Analysing the reasons may help companies determine practices that can help improve the ratio. For example, a company may experience a low ratio due to high production costs, whereas its competitors may minimise it by outsourcing production. Comparing the factors and identifying methods for improvement allows the company to rectify errors and produce better results in the following year.
Related: What Is A Business Valuation? (With Definition And Types)
Examples Of Calculating Asset Turnover Ratio
If you wish to calculate the asset turnover ratio of a company, here are some examples to help you better understand the process:
Samantha's company, Scenting Candles, has a net sale of ₹50 lakhs at the end of the fiscal year. According to her balance sheet, the asset value at the beginning of the year is ₹7 lakhs. The asset value at the end of the year is ₹9 lakhs. Calculating the asset turnover ratio:
Net sales: ₹50,00,000
Asset value at the beginning of the year: ₹7,00,000
Asset value at the beginning of the year: ₹9,00,000
Average asset value = (₹9,00,000 + ₹7,00,000)/2 = ₹8,00,000
Asset turnover ratio = ₹50,00,000 / ₹8,00,000 = 6.25
Samantha uses this ratio and compares it with her competition. She then determines if her company uses the assets efficiently to generate revenue.
Ram is an investor analysing companies to identify a good investment opportunity. He compares the asset turnover ratios of two companies to make an informed decision.
The first company generates a net sale of ₹1.3 crores in the fiscal year. Their average asset value was ₹50 lakhs. The second company generates a net sale of ₹1.5 crores with an average asset value of ₹75 lakhs.
Ram performs the following calculations:
Net sales of the first company: ₹1,30,00,000
Average asset value of the first company: ₹50,00,000
Net sales of the second company: ₹1,50,00,000
Average asset value of the second company: ₹75,00,000
Asset turnover ratio of the first company= ₹1,30,00,000/₹50,00,000 = 2.6
Asset turnover ratio of the second company= ₹1,50,00,000/₹75,00,000 = 2
Using these values and comparing them with the industry standards, Ram chooses the first company for his investment.
Please note that none of the companies, institutions or organisations mentioned in this article are associated with Indeed.
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