What is the Asset Turnover Ratio?

The asset turnover ratio is a financial efficiency ratio that measures how effectively a business uses its assets to generate sales. It shows how many dollars of revenue a business generates for every dollar invested in its average total assets during a specific time period. 

The Equation for the Asset Turnover Ratio is, 

The average total assets are calculated as:

The use of an average helps to level out any fluctuations in asset values during the period that the report covers to give an accurate reflection of asset performance over the year.

When considering how to calculate the asset turnover ratio, one needs to take into account that the ratio should be compared with similar firms within the same industry. 

For instance, asset-intensive industries such as manufacturing may have inherently low ratios compared to those firms that do not need much in terms of tangible assets.

Here is an Example to Compute the Asset Turnover Ratio

The company has sales of $10 million, beginning total assets of $4 million, and ending total assets of $6 million.

Step 1 – Calculation of Average Total Assets:

Average Total Assets = ($4 million + $6 million) ÷ 2 = $5 million

Step 2 – Calculation of Asset Turnover Ratio:

Asset Turnover Ratio = $10 million ÷ $5 million = 2

This implies that the firm is generating $2 worth of sales per $1 investment in average total assets.

Interpretation of the ratio

• Higher ratio: Indicates that the assets are being utilized for earning revenues and hence is typical for businesses that have fewer assets to begin with, such as retail or consulting businesses.
• Lower ratio: Suggests that the business has too many assets relative to its earnings from them or is facing slow sales, idle assets, or poor inventory management.
• Industry considerations: Businesses that are more capital-intensive in nature, like manufacturing, utilities, or telecommunications, typically have larger asset bases and may have lower asset turnover ratios than software- or service-oriented businesses. 

Asset turnover ratios are generally most meaningful when compared with businesses in the same or similar industries because asset requirements vary significantly across industries. 

How Can a Business Improve its Asset Turnover Ratio?

An increase in the asset turnover ratio can be achieved by increasing the level of sales produced by the assets already present in the business or by eliminating any unused assets. These include:

• Increase sales: Make more sales without much increase in the assets.
• Eliminate unused assets: Sell off or combine unused assets.
• Efficient management of inventories: Cut down the level of unused inventories.
• Improved operational efficiency: Make operations more efficient through technology.

Why Is Asset Turnover Important?

Asset turnover is used by companies in order to determine the effectiveness of their asset use in generating revenues. This measure enables management to uncover any idle assets and to make an assessment of efficiency as well as to compare asset performance with other companies in the industry.

Consistently low asset turnover might suggest that a company is earning low revenue with respect to the assets it holds. Nevertheless, it is necessary to consider this ratio together with other financial ratios and industry averages, as requirements for assets differ across different industries.

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