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What’s it: The asset turnover ratio is a financial ratio to measure the overall efficiency of business operations. It shows how well the company utilizes its resources to generate revenue. We divide revenue by the average total assets in the last two years to get it.
The higher the ratio, the better because the company uses its assets efficiently. Companies can generate more revenue for every dollar of resources they have.
Why is the asset turnover ratio important?
Assets represent the resources owned by the company. They flow economic benefits to the company, and in this case, we attribute it to its revenue.
How efficiently does the company utilize its assets? We measure it by the asset turnover ratio. It relates every dollar of revenue generated to the total assets owned. And, for management or investors, it is a metric to measure the overall efficiency of business operations.
This ratio also identifies strategic decisions by management, for example, related to production, whether to choose to operate on a capital-intensive or labor-intensive basis. For example, a capital-intensive business will have a lower total asset turnover than a labor-intensive business because it highly depends on fixed assets such as machinery, property, and equipment.
How to calculate the asset turnover ratio?
We need two inputs to calculate the asset turnover ratio. First, we need the revenue number as the numerator. It is presented in the income statement.
Second, we need the total assets figure as the denominator. Again, we find it on the balance sheet.
Most experts recommend using average total assets in calculating this ratio. To calculate it, we add up the total assets at the beginning of the year by the total assets at the end of the year, dividing the result by 2.
And, here is the asset turnover ratio formula:
- Asset turnover ratio = Revenue / Average total assets
For example, a company reports annual sales of $3 million in 2021. On its balance sheet, the company reports total assets of $1.4 million in 2020 and $1.6 million in 2021.
From this data, the average total assets are $1.5 million. Meanwhile, the asset turnover ratio equals 2 = $3 million/$1.5 million.
How to interpret asset turnover ratio?
A higher turnover ratio is better because it shows the company is more efficient in managing its assets. As a result, companies generate more revenue for every dollar of assets held.
Conversely, lower ratios underline less efficient operations. As a result, the company’s assets cannot generate sufficient revenue.
Then, we also have to explore why the ratio is high or low. For example, a high ratio may indicate too much revenue with too little investment. This is a signal for the company to invest more to support future sales. Otherwise, the sale is not sustainable in the long term due to inadequate asset support.
Then, in other cases, the company may report declining ratios. It can happen because the company invests too much in the plant, equipment, or other fixed assets but is not accompanied by an increase in sales. That could increase costs and depress profitability if the company fails to increase revenue.
Varies between industries
Evaluating the asset turnover ratio also needs to be compared with peer companies or industry averages. So, we can draw conclusions more objectively.
This ratio tends to vary, where it is higher in certain industries than in others. For this reason, the ideal ratio will vary by industry in which the company operates. Therefore, comparing this ratio between companies in different industries is less meaningful.
Take retail and utility companies as examples. Retailers tend to have high sales compared to utility companies. But on the other hand, retailers usually have lower total assets because they are less dependent on fixed assets. Thus, they tend to have a higher turnover ratio than utility companies.
Retail companies with an asset turnover ratio of 2.5 or more are considered good. Meanwhile, it may be too high for utility companies, where the ideal ratio ranges from 0.25 – 0.5.
