Here’s everything you need to know about the asset turnover formula in detail. So let’s get to the crux of the matter right away!
#1. What are assets?
Assets are things that can’t convert easily into cash. Some common examples of fixed assets are company equipment, vehicles, real estate, etc. They also include intangibles like goodwill, copyrights, etc. Fixed assets benefit the operational efficiency of the organization.
#2. What is an asset turnover ratio?
The asset turnover ratio measures the ability of a company’s assets to generate revenue or sales. It is an indicator of the efficiency with which a company can raise revenue through its assets.
If the asset turnover ratio is high, the company can generate a lot of revenue from its assets. But, on the other hand, if the asset turnover ratio is low, they do not use their assets efficiently.
There are a couple of things to keep in mind when you calculate your asset turnover ratio. One, intangible assets are excluded from the calculations. Two, no number can be arbitrarily dubbed as a “good” or a “lousy” asset turnover ratio. You always need to compare it with industry standards or companies of a similar size.
For example, manufacturing companies tend to have a much higher asset turnover ratio. However, the same is not true of a legal services company where the main currency is their legal knowledge.
#3. Why we calculate asset turnover
A. To know your benchmark
Your asset turnover ratio should take into account how your industry performs. For example, suppose you are into plastics manufacturing. In that case, you should compare your asset turnover ratio only with other companies doing the same thing.
The business model, the type of environment you operate in, the number of assets, and the size of your business will directly impact your asset turnover ratio. Also, some industries have an extremely high asset turnover ratio but report a low-profit margin. The opposite is also true.
B. To see where you stand
Suppose you know the average asset turnover ratio for a company in your industry. In that case, you can use it to compare your performance against your competitors.
If your ratio is above the industry average, it doesn’t necessarily mean that your productivity is higher; it could also be because of the depreciation of old assets. Likewise, suppose your asset turnover ratio is below the industry standards. In that case, it could mean that a new machine that you bought is giving you rich returns.
C. To look at other metrics
The asset turnover ratio is not the perfect tool. It is great at calculating capital productivity, but it doesn’t do a good job of measuring labor productivity.
As another example, you might have a fully functional machine that produces impeccable results. Still, if it doesn’t use 100% of its capacity, you will not get its full benefits. Finally, factors beyond your control – like the state of the economy – can influence the value of your assets and hence impact the asset turnover ratio.
#4. How to calculate total asset turnover using the asset turnover formula
The asset turnover ratio is a yearly calculation. The formula is:
Net Sales/ Average Total Assets
Step 1: Calculate your net sales.
When calculating the asset turnover ratio, it is better to use net sales instead of gross sales. The reason is that net sales refer only to products that have reached the hands of the customer. So use your income statement to find your gross revenue and subtract sales returns, discounts, damaged goods, missing goods, lost goods, etc. By doing this, you will get your net sales figure.
Step 2: Find the average of total assets.
You can find this information on your accounting balance sheet. Average total assets refer to the average value of your long-term and short-term assets for at least the past two fiscal years or the previous fiscal year.
Step 3: Divide
After you have the figures for net sales and average total assets, divide them. This will give you your company’s asset turnover ratio.
Example of using the asset turnover formula
Let’s take the case of Sirius Cybernetics Corp (if you spotted the Hitchhikers reference, well done you!). Let’s imagine the following values are for the year 2021.
- 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 (2020): $35,000
Asset turnover formula = Net Sales/ Average Total Assets ($85,000-$3,000)/($55,000+$35,000)/2)
Thus, the asset turnover ratio = 1.822. So, Sirius Cybernetics Corp makes $1.82 for every dollar of assets.
#5. What is a good asset turnover ratio?
With the asset turnover formula, no range or number is inherently “good.” It depends on the industry that you are in. If you want to see how you are faring, you need to check with competitors in the same field.
That said, if you have a higher turnover ratio, it is good for your business. Taking the example above, if the ratio we calculated was 0.822, Sirius Cybernetics Corp only makes $0.82 for every dollar of its assets. This should be a wake-up call for Sirius because they are punching below their weight in revenue generation.
A word to the wise: Don’t apply the asset turnover formula to your business if you are in the service sector. The chances are that you will get a significantly poor asset turnover ratio. But it is all right because not all businesses will find this metric helpful.
#6. How can you increase the asset turnover ratio?
A low asset turnover ratio can be due to poor planning, excess production, poor inventory management, or any number of causes. However, this ratio can tell investors a lot about how you manage your company. So here are some ways to increase your business efficiency and your ratio in turn.
If assets have either become obsolete or are not in use anymore, it is best to get rid of them. Look at it objectively – if there is any sense in retaining them, then do so. Otherwise, it is best to liquidate them as paying maintenance for them only affects your bottom line. Likewise, if other assets do not directly or indirectly contribute to your bottom line, then sell them.
Focus on increasing revenue
One of the best ways to improve your asset turnover ratio is to focus on increasing your revenue. Even though your teams might use the assets properly, a sales slowdown can affect the ratio. So encourage your team to come up with innovative ways to increase your revenue. For example, quirky sales promotion techniques and offers to attract the right kind of customers.
Better inventory management
Excess inventory or too little to meet the demand are disasters in the making – for your asset turnover. Tardy inventory management can lead to delays in delivery which in turn leads to delays in payment clearance. So, consider upgrading to the latest inventory management methodologies to keep your operations on track.
Rent out your assets
Suppose you have assets that are not of use right now but will be in a few months. Consider leasing or renting them out to someone who might need it. While it might not amount to a fortune, the payments you get from there will help with maintenance costs. Even better, you can plow any surplus money back into the business.
Instead of investing money in machines that you might use only occasionally, why not lease the equipment? You will pay less than the full market price, and you won’t have to account for it as a fixed asset either. That’s because when you take assets on a lease, the value of these assets is not added to the balance sheet. Instead, it is added to the company’s profit and loss account.
When you see that the asset turnover ratio is low, it could mean two things. Either the assets are not giving the revenue they should, in which case they are a loss on investment. Or it could mean that the assets are not used to their maximum capacity. So, first, find if there are deficiencies in the asset. If yes, then ensure their repair. Once the assets can function better, they will indeed produce more for you.
Improve debt collection
When the account receivables pile up, it can lead to problems with cash flow. However, it also reduces your asset turnover ratio. So, create a strict debtors policy that ensures that you get your payment as soon as possible. Then, you can either outsource the task to a collection agency or have a separate team to take care of it.
#7. Advantages of knowing the asset turnover ratio
Perfect for asset-heavy industries
Asset-heavy industries like manufacturing have many fixed assets in equipment, real estate, and others. Therefore, the asset turnover ratio offers an excellent advantage for manufacturing units by analyzing the ROI concerning top-line growth. When there is a high turnover ratio in manufacturing companies, it is clear that the fixed assets are working at their optimal level.
Helps with asset sale planning
When the assets turnover ratio is low, it can also mean that the assets are becoming obsolete. So the next step is to identify and sell them. Again, comparing your equipment with other companies in the same niche will help you know when to purchase new equipment.
Investors use the asset turnover ratio as one of the indicators of business efficiency. They can look at the efficient increment or decrement of the total assets. The investors would also be able to see 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 reinvest in fixed assets to maintain growth.
#8. Limitations of the asset turnover ratio
It doesn’t account for causes.
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 show what causes the impact on sales.
When there is a reduction in the ratio, everyone scrambles to see which assets are not working correctly. But in reality, the revenue drop might have happened because of something else. So if you are looking to understand what caused the change, then the asset turnover formula isn’t your best option.
It doesn’t show the performance of individual assets.
The asset turnover formula only gives a general efficiency rate. It does not provide data on individual assets, so there is no possibility to make an inter-asset comparison. As a result, it’s hard to find out the most efficient assets and those that are not adding much to the bottom line.
It’s not valid for all industries.
For asset-light industries, like a grocery delivery company, the asset turnover ratio has little relevance. Many startups have expanded rapidly by owning the operational part and outsourcing for capital assets.
It can be misleading.
The fixed asset turnover ratio is helpful for companies with high-value investments in assets. They usually have a board of directors who want to calculate the efficiency of the fixed assets compared with the company’s turnover. Unfortunately, many companies also use it as a benchmark of overall performance rather than efficiency.
It doesn’t account for accounting policies.
Businesses 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 assets turnover ratio throughout the industry.
You will even encounter cases where different companies have similar models. Still, the sales will show different fixed asset turnover ratios because of a difference in accounting policies. In other words, an average industry ratio is a number that you can’t fully trust unless the whole industry follows a standard accounting policy.
We play with the cards we’re dealt. Trying to generate as much revenue as possible with your existing assets is one of the easiest ways to make bank. And the asset turnover ratio is one of the best metrics to find how your business utilizes those assets.
Assets require periodic expansions and maintenance. So if you’re also looking for a good tool to automate and track your asset requests and maintenance requests, we got it. Sign up for a free account.
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