What is Asset Turnover Ratio?
Asset turnover ratio is the ratio between the net sales of a company and total average assets a company holds over a period of time; this helps in deciding whether the company is creating enough revenues to make sure it is worth it to hold a heavy amount of assets under the company’s balance sheet.
In simple terms, the asset turnover ratio means how much revenue you earn on the basis of the total assets you have. And this revenue figure would equate the sales figure in your Income Statement. The higher the number better would be the asset efficiency of the organization. It’s being seen that in retail industry this ratio is usually higher, i.e. more than 2.
On 31^{st} January 2016, Wal-Mart had total revenues of US $482 billion. And its total assets were US $203 billion at the beginning of the year and the US $199.6 at the end of the year. So to calculate the average total assets, we need to take the average of the figure at the beginning of the year and of the figure at the end of the year, i.e. (US$ 203 billion + US$199 billion)/2 = US$201.3 billion. Then the asset turnover ratio of Wal-Mart would be precisely (US $482 billion / US$201.3 billion) = 2.39x
So, if you have a look at the figure above you would visually understand how efficient Wal-Mart asset utilization is. The revenue is more than double of what assets they have.
Formula
To calculate asset turnover ratio, you need to find out the total revenue (the total sales or you can take the average of the sales figure at the beginning of the year and at the end of the year) and then divide it with total assets (or else you can take the average figure at the beginning of the year and at the end of the year).
Asset Turnover Ratio Formula = Sales / Average Assets
Now there are few things you should know before we can go to the interpretation of the ratio.
First, what do we mean by Sales or Net sales and what figure we would take to calculate the ratio? What are total assets and would we include every asset the firm has or there would be some exception?
When you calculate a ratio using “Sales”, it usually means “Net Sales” and not “Gross Sales”. This “Net Sales” come in the Income statement and it is called “operating revenues” for the company for selling its products or rendering any services. If you have been given a figure of “Gross Sales” and you need to find out “Net Sales”, look for any “Sales Discount” or “Sales Returns”. If you deduct the “Sales Discounts / Returns” from the “Gross Sales”, you would get the figure of “Net Sales”.
Now let’s come to the total assets. What would we include in total assets? We will include everything that yields value for the owner for more than one year. That means we will include all fixed assets. At the same time, we will also include assets which can easily be converted into cash. That means 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 in nature, like goodwill. We will not take fictitious assets (e.g. promotional expenses of a business, discount allowed on the issue of shares, a loss incurred on issue of debentures etc.) into account.
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Interpretation of Asset Turnover Ratio
This is a very important thing to consider as this will ultimately turn out to be what decision you would make about your company in the long run. Let’s interpret two options and let’s discuss these scenarios in detail.
If asset turnover ratio < 1
- If the ratio is less than 1, then it’s not good for the company as the total assets aren’t able to produce enough revenue at the end of the year.
- But this is subject to an assumption. If the asset turnover ratio of the industry in which the company belongs is usually less than 0.5 in most of the cases and this company’s ratio is 0.9, then this company is doing well irrespective of its lower asset turnover ratio.
If asset turnover ratio > 1
- If the ratio is greater than 1, it’s always good. Because that means the company is able to generate enough revenue for itself.
- But this is subject to an exception. For example, let’s say the company belongs to a retail industry where the company keeps their total assets low and as a result, the average ratio is always over 2 for most of the companies.
- In that case, if this company has asset turnover ratio of 1.5, then this company isn’t doing well. And the owner has to think about restructuring the company so that the company would be able to generate better revenues.
Here one thing every company should keep in mind. If you want to compare asset turnover ratio with another company, it should be done with the companies in the same industry.
Example
Let’s understand this with an example.
Particulars | Company A (in US $) | Company B (in US $) |
Gross Sales | 10000 | 8000 |
Sales Discount | 500 | 200 |
Assets at the beginning of the year | 3000 | 4000 |
Assets at the end of the year | 5000 | 6000 |
Let’s do the calculation to find out the asset turnover ratio for both the companies.
First as we have been given Gross Sales, we need to calculate the Net Sales for both of the companies.
Company A (in US $) | Company B (in US $) | |
Gross Sales | 10000 | 8000 |
(-) Sales Discount | (500) | (200) |
Net Sales | 9500 | 7800 |
And as we have the assets at the beginning of the year and at the end of the year, we need to find out the average assets for both of the companies.
Company A (in US $) | Company B (in US $) | |
Assets at the beginning of the year (A) | 3000 | 4000 |
Assets at the end of the year (B) | 5000 | 6000 |
Total Assets (A + B) | 8000 | 10000 |
Average Assets [(A + B)/2] | 4000 | 5000 |
Now, let’s calculate the asset turnover ratio for both the companies.
Company A (in US $) | Company B (in US $) | |
Net Sales (X) | 9500 | 7800 |
Average Assets (Y) | 4000 | 5000 |
Asset Turnover Ratio (X/Y) | 2.38 | 1.56 |
Let’s say both companies, A and B are from same industry. In that case, we can do a comparative analysis. It’s clearly seen that the ratio of Company A is more than the ratio of Company B. As it is assumed that they both belong to the same industry, we can conclude that Company A is able to utilize their assets better to generate revenue than Company B.
But, let’s say Company A and Company B are from different industry. Then we won’t be able to compare their asset turnover ratio against each other. Rather, in that case, we need to find out the average asset turnover ratio of the respective industries and then we can compare the ratio of each company.
Nestle Example
We have discussed how you would be able to calculate the asset turnover ratio and would also be able to compare among multiple ratios in the same industry.
Let us now compute Nestle’s Asset Turnover and what can we interpret from the values obtained.
The first step involves extracting the relevant data for Asset Turnover. For Asset Turnover, you require two set of Data – 1) Sales 2) Assets.
You can access Nestle’s Annual reports from here.
Once you have the data for say last 5-6 yeras, you can put those in excel as shown below. Calculate the Average Assets size for each year.
The next step is to calculate Asset Turnover = Sales / Average Assets
Below is Nestle’s Asset Turnover for the past 15+ years.
source: ycharts
So from the calculation, it is seen that the asset turnover ratio of Nestle is lesser than 1. But that doesn’t mean it’s a lower ratio. We need to see other companies from the same industry to do a comparison.
Also, you may note from this chart, the Asset Turnovers has shown a decreasing trend over the past 15 years.
Let’s take another example of Asset Turnovers.
Colgate vs P&G – battle of Asset Turnover Ratios
Let’s look at the two companies Colgate and P&G.
source: ycharts
- For the past 10 years, Colgate has been maintaining a healthy Asset Turnover of more than 1.0x
- On the other hand, P&G is facing challenges in maintaining an Asset Turnover. Currently, its asset turnover is 0.509x.
- Colgate’s Asset Turnover is 1.262 / 0.509 = 2.47x better than that of P&G.
- We would be able to say that P&G has to improve their asset utilization so as to increase the revenue generation through assets.
Limitations
As everything has its good side and bad side, asset turnover ratio has two things that make this ratio limited in scope. Of course, it helps us understand the asset utility in the organization but this ratio has two shortcomings that we should mention.
- It includes all idle assets: As in the computation, we take the figure of total assets at the end of the year; we also take into account idle assets which shouldn’t have been included.
- It gives a general efficiency ratio: From this ratio, it’s impossible to extract the individual asset utilization data which limits our understanding of the efficiency of an individual asset.
Asset Turnover Ratio Video
Related Articles
- Examples of Assets in Accounting
- Tangible Assets
- Current Assets
- Ratio Analysis
- PE Ratios
- Financial Liabilities Ratios
- Cash Ratio
- DSCR Ratio
- Current Ratio
- Working Capital Ratio
In the final analysis
You certainly should use asset turnover ratio for understanding the efficiency of your assets in the organization, but don’t forget to have other ratios handy, like cash ratio, current ratio, quick ratio, fixed asset turnover ratio, equity turnover ratio so as to understand the overall picture of the company.