What is Asset turnover ratio?
An equation of your asset turnover ratio help’s you figure out how you are using your assets to generate sales.
In much easier terms, finding your asset turnover can help you figure out how many sales you can generate from every dollar according to the value of assets you are having.
This accounting principle can be a peek into the efficiency of your business, whether or not you can use the assets you are having, both fixed and current, for generating sales.
Typically as your total asset turnover ratio is only measured once every year, you can understand that large purchases can easily skew your current ratio, even if they were made months ago.
So, in this, you might find that your asset turnover ratio isn’t an accurate reflection of your current efficiency.
What the Asset turnover ratio can tell you?
Typically, the total asset turnover ratio can be calculated on an annual basis. The higher the asset turnover ratio, the better the company performs since the higher ratios mostly imply that the company can generate more revenue per dollar of the assets.
In certain sectors than in others, the asset turnover ratio can be higher for companies.
E.g., Retailers and consumer staples have relatively small assets on the basis and have high sales volume.
Thus, they might be having the highest average asset turnover ratio. Conversely, the company’s utilities and real estate must have large asset bases and even low asset turnover.
Since this ratio can also widely vary from one industry to the next industry, the asset turnover ratios of a retailer company and a company related to telecommunications would not be much very productive. In comparisons are only meaningful when they are made for different companies within the same sector.
A small description on Assets turnover ratio–
The calculation of the asset turnover ratio can be considered by the average of the assets that can be held by the company at the beginning of the year and the end of the financial year and keeping the total number of assets as the denominator.
This ratio can be higher for the companies in various certain sectors than others.
E.g., if the retail sector is yielding the highest asset turnover ratio. According to the survey, the retail sector can score an asset turnover ratio is 2014 is 2.05.
Generally, retail companies have small asset bases but have high sales volumes. The asset turnover ratio can be a key constituent of DuPont analysis.
It is a method in which the DuPont Corporation began using at some point in the 1920s. DuPont analysis broke down return on equity, total asset turnover, profit margin, and financial leverage into three parts. Calculating the asset turnover ratio can be done by dividing the net sales value by the average of total assets.
(Note: DuPont analysis is an expression that breaks ROE into 3 parts. This name has comes from the DuPont Company that mainly began using this formula in late 1920s. DuPont explosives salesman name Donaldson Brown invented this formula in an internal efficiency report in 1912.
Formula of Asset turnover ratio-
Understanding the formula asset turnover ratio-
Assets Turnover Ratio = Net Sales Revenue / Average Total Assets
Net Sales Revenue = Gross Sales Less Sales Return
Average Total Assets = Beginning Assets + Ending Assets / 2
Beginning Assets = Assets at start of Financial Year
Ending Assets = Assets at end of Financial Year
So, what is the formula of the asset turnover ratio?
According to the formula, you need to divide the net sales with the average total assets for getting the asset turnover ratio.
You can find the net sales in the company’s income statement. Utilization of the net sales is primarily for calculating the ratio returns and refunds.
Withdrawal of returns and refunds should be out of the total sales to measure a firm’s asset capable of generating sales accurately.
To calculate the average total assets, you can add the beginning, total asset and ending total asset balances and later divide the result by two.
It is just a basic type of average based on a last two-years balance sheet. While there is always have been option for utilizing a weighted average calculation, more in-depth, this is not mandatory.
Analyzing the formula of the asset turnover ratio-
So, the ratio, which outlines the efficiency level of a company’s abilities for using the assets for generating sales, also makes sense that a higher ratio is much more favourable.
A higher turnover ratio usually points out that the company can utilize its assets more effectively. On the other side, lower ratios highlight that the company might deal with management or production issues.
A company with an asset turnover ratio of 1 then implies that the firm’s net sales are the same as this average of total assets for an complete one year.
In other words, this would also mean that the company generates one dollar of its sales for every dollar the firm has invested in assets.
Like other financial ratios, the asset turnover ratio is also evaluated depending on industry standards.
That’s man because some given industries utilize assets much more effectively in comparison to others.
Therefore, to get a real sense of a firm’s efficacy level, it makes sense to compare the numbers with those of other companies that operate in the same industry.
Calculation of asset turnover ratio-
Now, you should know a few things before we can go ahead with interpreting the ratio.
First, what we mean by Sales or Net sales, and what we would take to calculate the ratio? What do we mean by the total assets, and what we would include in every asset that the firm is having, or there would be some exceptions?
When you calculate a ratio using “Sales,” it usually means “Net Sales” and not “Gross Sales”.
This “Net Sales” is included in the Income statement. It is also called “The operating revenues” for the company and for selling its products or rendering any of its services.
If you have given a figure of “Gross Sales” and if you need to find out “the net sales”, looking for any “Sales Discount”. If the deduction is made like the “Sales Discounts / Returns” from the “Gross Sales”, you would be getting the figure of “The net sales.”
Now let’s take the total assets. What would we include in total assets? We will be including everything that will yield a value for the owner for even more than a particular year.
It means that we will be including all the fixed assets. At the same time, we will also include those assets that are converted easily into cash. It also means that we would be able to take current assets under total assets.
And we will also include intangible assets that have value, but they are non-physical, like goodwill. We would be taking fictitious assets (e.g., promotional expenses of a business, discount allowed on every share, incurring the loss while issuing the debentures, etc.) into account.
Below mentioned points are to make the calculation of assets turnover ratio more understandable:
STEP 1- Find your net sales.
Your net sales number can be located on your income statement, also known as your profit and loss statement. What goes into that net sales figure? It is your total sales number, minus any returns, damaged goods, missing goods, etc.
Rather than gross sales, your net sales are the more accurate figure to use when you’re generating your asset turnover ratio. Remember that net sales only account for the products that end up in your customers’ hands at the end of the year.
STEP 2- Find the average total assets.
The average value of your long-term assets and short-term assets over the past two years is represented. Reaching this number, you will need two years of your asset totals, and you can even get this information on your accounting balance sheet. Once you have your current year number and your previous number, add them up and divide them by two for the average.
STEP 3- Divide.
Once you have exactly found your net sales and your average total assets, you’ll need to divide your net sales by your average total assets to complete the asset turnover ratio formula.
What is a good asset turnover ratio?
“Good” is a relative term in business. So, making a good asset turnover ratio for your business is not necessarily the same as your neighbour’s.
Every industry has its benchmarks, and you will need to check your benchmark to see if you will be getting the most out of your assets.
It is also said that you should understand your number, which indicates in a vacuum, too. It is all told that if the asset turnover ratio is higher, then it is.
A higher number usually indicates that you are efficiently using your assets. For instance, if an asset turnover ratio is 1.4, you generate $1.40 of sales behind every dollar of your assets that your is a business has. A ratio of 0.4 also means that you are only generating $0.40 for every dollar you have invested in your assets.
In some sectors, like retail, you will more likely see a good ratio of around 2. Others, particularly that those are service-based, will be having a much lower ratio.
That is why it is important, especially when it comes to knowing what is relevant for you. You don’t have to judge yourself on a metric that you have set for yourself, especially when it is meant for helping you improve your business.
Why is your asset turnover ratio important?
Your business’s asset turnover ratio can indicate whether or not you are efficiently managing and optimizing your assets to produce the highest volume of possible sales. If you want, you can also maximize your output with as little input as possible, so it is considered an important factor to keep in mind.
But you are not the only one who can take benefits from the understanding of your Net fixed asset turnover ratio.
Suppose you are a small business holder looking for business financing or applying for any credit product. In that case, it can be even possible that this ratio can come into action during the application process.
That is because this ratio can give creditors a clear line of sight that whether or not your company is optimally managing. It also help in the capital turnover ratio
Similarly, these investors will be very interested in the result of this accounting formula. As a startup seeking early-stage investment, venture capitalists will be taking a gamble on you if your company has low revenue. Any study can indicate that your strong management can only help.
How to improve your turnover ratio?
So if you want to get your asset turnover ratio better? You can also approach this by working on a few different areas of your business:
As your sales are on one whole side of your assets turnover ratio, there is a need on focusing much of your efforts on boosting these numbers. Of course, it is easier to say that it is done. But here, we have a few considerations which can be used as a slingshot so that the point can alter your sales processes and even increase the numerator of your asset turnover ratio formula.
- It helps in generating more sales. You can even try to pick up the pace of your company’s sales. Perhaps this means focusing on more lead gen or expanding into new markets that you haven’t considered before.
- Focus on higher margins. Examine your production processes. If you are efficient, then there is a possibility that you can even subsequently examine your prices with the right suppliers and materials. It highlights the question that is pricing correctly for your industry and market or not.
- You were adding something new to your repertoire that there is no requirement of investment. Perhaps, if you can offer a new service or product that does not require you to put more money into assets, then you might be able to generate new sales.
- Make a plan to move unsold inventory. You might be nervous about moving your old and unsold inventory because you will take a hit or even experiencing a low margin than you think you should. But on the other side, a lower margin is better than having entirely dead stock.
As we are having tighter control over our inventory, including returns and damaged goods, it will be helping you in bringing up your net sales number and lower your cost of goods that are sold. Ultimately, it will be increasing your ratio of assets turnover.
- You are focusing on a reduction in shrinkage. Any lack of compatibility between the inventories you are thinking and having can even sell the inventory that you can sell; means lost profits.
Setting up a strong inventory management system is necessary not to lose track of your products due to damage, stolen, or confusion.
- You are figuring out that why customers are returning your company’s products. See if you can encourage your customers to keep certain products by addressing their issues before they even finalize in returning the products.
Or, even consider creating a store credit system so that you won’t lose the sales revenue even if your customers do even return products.
You can even consider a financing/debts plan for your customer. If you can work in a business that can be service-based, issue feedback forms, or even directly contact your customers to understand why they are not renewing. According to that, you can adjust your offerings.
If you want to generate more with less, then keep in mind the below following points:
- It is necessary to make sure that you have the right assets in your hand. If you have a piece of old machinery or equipment that is not used, consider them liquidated and turn them into cash.
Many businesses nearly do not run as lean as they can and do not have to own some of their assets.
When you take a survey of your assets, consider that if you might even benefit from the leasing equipment rather than buying this kind of expensive assets, especially if you are using certain equipment just a few times a year.
Streamlining your assets from your business will decrease the denominator from your account receivable turnover formula.
- Either team up with other businesses or own fewer or fewer assets to share common spaces, pieces of tools, or machinery of the company.
Especially in your early days of business when you are first building up your product, at that time, it might be necessary to have regular access to many expensive types of equipment.
Still, it might be better for your company’s balance sheet to divide up and share that equipment and even their expenses and among several businesses.
In this way, you will also be able to whittle down the denominator of your assets ratio turnover.
So as we have learned that this makes the asset turnover ratio of utmost importance is that it gives creditors and investors a general idea of how well a company is managed to produce sales and products. Thus, most analysts utilize this ratio before considering any investment to make a sensible and informed decision.
Frequently Asked Questions-
What is good asset turnover ratio?
– In a retail sector, an asset turnover ratio more or having a ratio of 2.5 can be considered as good. In contrast, a company in the utility sector is more likely to aim for between 0.25 and 0.5 of an asset turnover ratio.
How to calculate asset turnover ratio?
– The asset turnover ratio is necessary to measure the efficiency of a company’s assets in generating revenue or sales. It can compare it to the annualized percentage of the dollar amount of revenues to its total assets. Thus, calculating the asset turnover ratio can be done by dividing the net sales or revenue by the average total assets.
What is total assets turnover ratio of 3.5 indicates?
– Remember that the formula for asset turnover ratio is = sales revenue / average operating assets. It means that if the asset turnover ratio is 3.50, that sales were $3.50 and assets $1, not the other way around. The formula does not include the gross profit or net income.
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