Let’s get to the crux of the matter right away!
What Is Asset Turnover Ratio?
Using the asset turnover formula, we can find the asset turnover ratio, which measures the efficiency of a company’s assets to generate revenue or sales. It is considered an indicator of the efficiency in which a company generates revenue based on its assets.
If the asset turnover ratio is high, the company can generate a lot of revenue from its assets. On the other hand, if the asset turnover ratio is low, they do not use their assets efficiently.
What Are Assets?
Assets are things that cannot be converted easily into cash. Some of the common examples of fixed assets are company equipment, vehicles, real estate, etc. They are of benefit for the operational efficiency of the organization. So when fixed assets are being talked about, they also include intangibles like goodwill.
When you are calculating the asset turnover ratio, the intangible assets are usually subtracted from it. No number can be arbitrarily associated with a good or a bad asset turnover ratio. You always need to compare it with the industry standards or see the ratio of companies of similar size.
For example, manufacturing companies tend to have a much higher asset turnover ratio. The same cannot be said of a legal services company where the main currency is their legal knowledge.
Why Is It Important To Calculate The Asset Turnover Ratio?
The asset turnover ratio measures the efficiency with which businesses operate. It tells how they are using their existing assets to generate sales. When you want to see where your business stands, you cannot compare a mechanical auto parts company to a tile manufacturing company. While both of them are in manufacturing, their business model is different.
There are bound to be exceptions when you use the asset turnover formula to calculate it. The state of the economy or other extraneous factors can have a lot of say regarding the asset turnover ratio. Also, some companies are usually asset-heavy while others are asset-light. If you think that the asset turnover ratio always shows the right meaning, you could be wrong. You need to evaluate the answer you get by using the fixed asset turnover formula much more carefully. As we said earlier, you need to benchmark the asset turnover ratio only against other companies in the same industry. Believe it or not, some industries have an extremely high asset turnover ratio but only report a low-profit margin. The opposite is also true.
How To Benefit From The Asset Turnover Ratio?
Here is how you can use the asset turnover ratio for the benefit of your business.
#1 Helps To Know Your Benchmark:
Your asset turnover ratio should be only taken into account based on how your industry performs. If you are into plastics manufacturing, you should compare your asset turnover ratio only with other companies doing the same thing. The type of environment you operate in and the size of your business will have a direct bearing on your asset turnover ratio.
#2 See Where You Stand:
If you know the average asset turnover ratio for a company in your industry, you can use it to compare your performance against your competitors. When your asset turnover ratio is above the industry average, it doesn’t necessarily imply that your productivity is higher; it could also be because of the depreciation of old assets. Likewise, if your asset turnover ratio is below the industry standards, it could also imply that a new machine that you bought is bringing you rich dividends.
#3 Look At Other Metrics:
The asset turnover ratio is not perfect by default in terms of what it helps to achieve. It is great to calculate capital productivity, but it doesn’t do a good job at measuring labour productivity. You might have a fully functioning machine that works perfectly well and produces impeccable results. Still, if it doesn’t use 100% of its capacity, you will not get its full benefits.
How To Find Total Asset Turnover Using Asset Turnover Formula
The asset turnover ratio is calculated annually, and you can use the asset turnover ratio formula:
The asset turnover formula is Net Sales/ Average Total Assets to get asset turnover ratio.
Step 1: Calculate Your Net Sales:
Find out your net sales with the help of your income statement. You should subtract any returns, damaged goods, missing goods, lost goods, etc., when calculating net sales. When calculating the asset turnover ratio, it is better to use net sales instead of gross sales. Net sales only refer to products that have reached the hands of the customer.
Step 2: Find The Average Of Total Assets:
You can find this information on your accounting balance sheet. It represents the average value of your long-term and short-term assets, at least for two years.
Step 3: Divide
After you have your average net sales and average total assets, you can use the asset turnover formula to divide them to get your asset turnover ratio.
Example of using the asset turnover formula:
Consider the following values are for the year 2020
Total sales in that year: $85,000
Lost goods, damages, etc. of that year: $3,000
This year’s assets: $55,000
Last year’s assets (2019): $35,000
Asset turnover formula= Net Sales/ Average Total Assets
By using the asset turnover formula, you will get the asset turnover ratio as = 1.822
For this business, it makes $1.82 for every dollar of assets.
What Is A Good Asset Turnover Ratio?
When you use the asset turnover formula to calculate the asset turnover ratio, no range or number is considered “good”. It depends on the industry that you are in. If you want to see how you are faring with respect to utilizing one’s assets to generate revenue, you need to check with competitors in the same field.
And, if you have a higher turnover ratio, it is good for your business. If the asset turnover ratio we calculated using the asset turnover formula was 0.822, it means that the business only makes $0.822 for every dollar of its assets. This should be a wake-up call for businesses as it means that they are punching below their weight when it comes to generating revenue.
Do not think of applying the asset turnover formula to your business if you are in the service sector. The chances are that you will find a significantly poor asset turnover ratio. But it is all right because not all businesses will find the asset turnover ratio useful. There are other metrics that you might want to judge your business on.
How Can A Company Raise The Asset Turnover Ratio?
Since asset turnover ratio is all about increasing the company’s efficiency in managing its resources to increase sales, there is no doubt that it is pivotal to the company. When there is a high turnover ratio, it shows that there are certain things that the company is doing rightly.
The asset turnover ratio tells the investors about how the company is managed. A low asset turnover ratio could be because of poor planning, unnecessary production, poor inventory management policies, and so on. So the onus is on the company to show a high asset turnover ratio.
If there are assets that have either become obsolete or are not in use anymore, it is best to get rid of them. Look at it objectively and if there is any sense in retaining them, then do so. Otherwise, it is best to liquidate it as it is not in your best interests to pay maintenance for them. If other assets do not contribute to your bottom line, directly or indirectly, then they should be disposed of.
Focus On Increasing Revenue
One of the best ways to improve your asset turnover ratio is to focus on increasing your revenue. Even though the assets might be used properly, the chances of sales being slow is always there. So you need to come up with innovative ways to increase your revenue. Use sales promotion techniques and offers to attract the right kind of customers.
Better Inventory Management
Having excess inventory or not being able to meet the demands are disasters in the making. It can lead to customer dissatisfaction which will also decrease your revenue. The company should be on top of its inventory management needs so that the supply always meets the demands. When the operation is a little tardy, there are bound to be delays in getting the product in the customer’s hands. It will also result in a delay in getting the payments cleared. The business should invest in the latest inventory management methodologies so that all the stakeholders are kept happy.
Rent Out Your Assets
If there are assets that are not of use right now but are important for your business in a few months, then look at options to lease them to someone who might need it. While it might not amount to a fortune, the payments you get from there could help with the maintenance of the equipment and maybe a little more that could be invested back in the business.
Instead of buying big machines that might not be of use to you throughout the year, lease this equipment. You wouldn’t have to pay the full price, and it is not necessary to account for it as a fixed asset either. When the company takes the assets on a lease, the value of assets is not added on the balance sheet but the Profit and Loss account.
When you see that the asset turnover ratio is low, the assets are not giving the revenue they should. It could also mean that the assets are not being used to their maximum capacity. Find if there are deficiencies in the asset. If yes, then ensure that they are repaired. Once the assets can function better, they will indeed produce more for you.
Improve Debtors Collection
When the accounts receivable piles up, it can lead to problems with cash flow. This will affect the overall operations of the business. It also reduces your asset turnover ratio. Create a strict debtors policy that ensures that you get your payment as soon as possible. You can either outsource the task to a collection agency or have a separate team to take care of it.
Advantages Of Knowing The Asset Turnover Ratio
Perfect For Manufacturing Industries
Manufacturing companies are the ones that have a lot of fixed assets in the form of equipment and other assets. Asset turnover ratio offers an excellent advantage for manufacturing units. It analyzes the return on investments with respect to top-line growth. When there is a high turnover ratio in manufacturing companies, it is a clear indication that the fixed assets are working at their optimal level.
Helps In The Asset Sale Planning
When the fixed assets turnover ratio becomes low, it means that the assets that are used for your operations are becoming obsolete. So the next step is to sell them. When you compare with other companies in the same niche, you will know when new equipment should be purchased.
Investors use the asset turnover ratio as an indication of how well the business can utilize the assets that it has. They can look at the efficient increment or decrement of the total assets. The investors would also be able to see what we’re the kind of steps that the business took to ensure that they increased the asset turnover. It also allows them to know when they should again invest in fixed assets to maintain the growth.
Limitations of Asset Turnover Ratio
Doesn’t Account For Profits
The fixed asset turnover ratio only shows the efficiency with which the business is using its assets. In other words, it shows us the correlation between fixed assets and total sales, but it doesn’t dwell upon what caused the impact on the sales.
When there is a reduction in the asset turnover ratio, everyone scrambles to see which assets are not working correctly. Still, in reality, the revenue drop might have happened because of something else. So if you are looking to understand what caused the profits, then asset turnover ratio isn’t your best option out there.
Doesn’t Give Info On The Performance Of Individual Assets
When you are calculating the asset turnover ratio, it gives a general efficiency ratio. It does not extract data on individual assets. It means that there is no possibility to make an inter-asset utilization comparison. So it is impossible to find out which are the most efficient assets and which are the ones that are not adding much to the bottom line.
Cannot Be Extrapolated For All Industries
For asset-light industries, say like a technology company, the asset turnover ratio doesn’t hold a lot of relevance. It is only valid when you are employing it in businesses that have manufacturing units.
Can Be Manipulated
The fixed asset turnover ratio is helpful for companies that have high-value investments in assets where the board of directors want to calculate the efficiency of fixed assets when compared with the turnover of the company. The significant disadvantage is that it is used as a performance measuring benchmark.
Doesn’t Consider Accounting Policies
Businesses that are in the same niche might not use the same type of accounting policies, especially when it comes to calculating depreciation. It can even skew the results while comparing the fixed assets turnover ratio throughout the industry.
In fact, you will even encounter cases where different companies have similar models, but the sales will show different fixed asset turnover ratios because of varied accounting policies. This means that the fixed asset turnover ratio of the industry is a number that cannot be entirely trusted unless the accounting policies are similar across the entire spectrum.
Asset turnover ratio is an important metric that businesses should use to find how they are utilizing their assets to generate revenues. Trying to generate as much as possible with the help of the assets that you have by going lean is one of the easiest ways for businesses to make a bank. There are no doubts about that.
Your asset turnover ratio will tell your business managers how efficiently your business is being run. If your asset turnover ratio isn’t at the ideal figure you want to be based on benchmarking against your competitors, don’t worry. You can always make the necessary changes to improve those numbers. By working on increasing the effectiveness of your assets while discarding those that don’t bring any value, you will increase the worthiness of your business.
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