How to Analyze Asset Turnover Ratio?

What is Asset Turnover Ratio?

The assets turnover ratio explains the turnover of assets into sales. It is an efficiency ratio that implies a firm’s ability to generate sales from the assets. For this purpose, the net sales figure is compared with the total average assets.

The total asset turnover ratio measures net sales as a percentage of assets to show how many sales are created from each rupee of assets.

Example − An asset turnover ratio of 0.5 shows that each rupee of assets generates 50 paise of cash.

How to Calculate Asset Turnover Ratio?

The formula for calculating Asset Turnover is the following −

$$\mathrm{Assets\: Turnover\:=\:\frac{Net \:Sales}{Average \:Total Assets}}$$

The net sales figure can be found in the income statement of the company. Returns and refunds must also be considered in order to get an appropriate figure for the firm’s ability to generate sales.

Average total assets are calculated by adding the beginning and ending total assets and then dividing by 2. A more sophisticated way of measuring average via weighted average figure can be applied but it is not mandatory.

How to Analyze Asset Turnover Ratio?

The assets turnover ratio shows how efficiently a company utilizes its assets to generate sales. A higher rate of assets turnover is more impressive because it shows more ability of a company to convert assets into sales. A lower ratio means that the company is inefficient in converting assets to sales due to production or management malfunctions.

A ratio of 1 means that the net sales of a firm equal the average total assets for a given year. In simple words, the company is earning Rs. 1 for every Rupee invested in the project.

Use for Industry Analysis

Like most other ratios, the assets turnover ratio is also used for industry analysis. There are some industries that use assets more efficiently than others. Therefore, a comparative approach can properly imply how well a firm is employing its assets to generate sales.

The assets turnover ratio is a measure of the efficiency of a firm in using its assets to generate cash. Investors, lenders, and creditors usually look for a high asset turnover ratio because it means that the company will be able to convert its assets into sales easily. That, in turn, will provide the liquidity required to pay the resourced funds back more easily.

Use for Investors or Creditors

The assets turnover ratio also gives the investors, creditors, and other stakeholders an idea of how a company is managed, and how well it is converting its cash from the assets to produce products and sales.

Use for Analysts & Shareholders

Sometimes, analysts and stakeholders may be specifically interested in judging how efficient a company is in converting fixed assets and current assets to generate sales. For these purposes, more specific calculations fixed assets turnover ratio and working capital ratios are calculated respectively.

Example − Suppose ABC is a mobile manufacturing company that wants to attract more investors to cater to its rapid expansion and growth. He meets an angel inverter for this purpose. The investor is interested in knowing how well ABC converts its assets into sales.

For this purpose, ABC considers its following items −

• Beginning Assets: Rs. 50 Crore

• Ending Assets: Rs. 100 crore

• Net Sales: Rs. 25 Crore

So, the Assets Turnover Ratio =$\frac{25}{\frac{100+50}{{2}}}\:=\:\frac{25}{75}\:=\:0.33$

This shows that ABC generates only 33 paise’s sales for every Rs. 1 of assets. This is not a very good figure and shows the inefficiency of ABC in converting its assets to sales. The angel investor therefore may not be interested in providing funds to ABC.

Conclusion

In this way, we can calculate the assets turnover ratio to find the relationship between total average assets and net sales, indicating a true behavior that shows a firm’s efficiency to meet its goals in terms of sales and therefore, profitability.