Asset Turnover

A financial ratio used to analyze the efficiency of the assets in generating revenue for the company

The asset turnover (ATO) ratio is a financial ratio used to analyze the efficiency of the assets in generating revenue for the company. 

The following formula calculates it: 

Asset Turnover = Net Sales / Average Total Assets 

Where 

Net Sales = Gross Sales - Returns - Discounts - Allowances

Average Total Assets = (total assets at the beginning of the year + total assets at the end of the year) / 2

The ratio is an activity ratio used in DuPont analysis and will be a part of the fundamental analysis of the company. It is calculated annually every financial period or financial year. 

The company's profit margins are inversely proportional to the ATO of the company, which states that businesses with higher profit margins have low asset turnover, and those with low-profit margins have higher turnover.  

It is further classified into 

  1. Fixed asset turnover and 
  2. Working capital turnover

A higher ratio is considered good as it suggests efficient and effective use of assets instead of a lower one, indicating that the company is not using its resources and assets properly and efficiently. 

A lower ratio can suggest that the company has over-invested in the fixed assets. 

Increasing revenue or sales, selling assets, promoting efficiency, leasing assets instead of buying them, improving inventory management, and using technology are some factors that can help companies enhance or raise their ratio. 

Understanding the ratio

The ATO ratio is observed to be higher in certain sectors, especially retail, as it has fewer assets and more sales. As we know the formula for calculating, we can measure the level of efficiency of the assets to generate income for the company in the long run. 

Understanding

This ratio is also considered useful for comparing similar companies in the same sector. The ratio is extremely affected by the sale of huge assets and purchases of huge assets in a financial year. 

Importance

This ratio can help get a better view of the company compared to the sales figures. But, it does not measure how well the company is earning profits. ATO differs from return on assets as an increase in sales may or may not be expressed as an increase in profits. 

Generally, a company wants to maximize its returns on every investment, so higher turnover suggests better or efficient management of the company resources. 

The fixed assets turnover ratio (FATO) measures the efficiency of the fixed assets to generate sales for the company. It is calculated using the following formula: 

Fixed Asset Turnover = Net sales / Total Fixed Assets

Where a higher ratio indicates efficiency in utilizing assets, and a lower ratio indicates the inability of the company to use the fixed assets to generate revenue efficiently. 

Effect of the ratio on the financial performance of a company

It measures how the assets owned by the companies are used to generate sales. This has a significant effect on the financial performance of the company. 

If the asset turnover is higher, the company has a higher level of financial performance because the assets are utilized efficiently while operating activities.

It helps the investors review the company's trends and learn whether asset usage is improving or declining. It decreases when a company invests in purchasing large assets. 

Many other factors like seasonality, employment, and inventory affect the company's ATO ratio in financial periods. 

Some of the ways through which a company improves its ratio are Just-in-time (JIT) inventory management, replenishing inventory, and stocking items with high sale probability. 

Changing depreciation methods of accounting decreases growth and increases the asset turnover ratio. 

Investors, creditors, and analysts are interested in measuring how the company converts its assets into sales. In this analysis, the investors search for specific ratios such as the working capital and fixed asset turnover ratios to measure the efficiency of the asset utilization.

Example of the ATO ratio and its interpretation

Let us assume two automobile companies: Company X and Company Y. 

= net sales / average total assets

= 185000 / 202500 = 0.91

= net sales / average total assets

 

= 250000/ 285000

= 0.87

Example
Total assets at the beginning $240,000$275,000
Total assets at the end$165,000$296,000
Average total assets =(240,000 + 165000) / 2  = $202,500=(275000 + 296000)/ 2 = $285,500
Net sales $185,000$250,000
Asset turnover= net sales / average total assets

=185000 / 202500

= 0.91

= net sales / average total assets

= 250000 / 285000

= 0.87

The asset turnover was calculated for the two companies is calculated above with the usage of proper formulas.

Example

1. Comparison between the two ratios: On comparing both automobile companies, we can see that the average total assets and net sales are quite high in company Y compared to company X. But, while calculating the asset turnover, we observe that company Y has a lower ratio than company X, with a difference of 0.04. 

2. Interpretation of the two ratios: Company X has a turnover ratio of 0.91 & company Y has a ratio of 0.87. This means that company X is utilizing their assets more efficiently than Y. The higher turnover rates also translate into higher profitability.

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Researched and authored by Vanshika Nakul | LinkedIn 

Reviewed and Edited by Aditya Salunke I LinkedIn

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