Asset turnover is one of the key components of determining a business’ return on equity. It is one of the components of the DuPont analysis and a common measure of how well businesses utilize their assets to generate revenue.
This article will provide an in-depth overview of what asset turnover is all about. It will provide a clear definition of the ratio and illustrate its use in different industries. It will also explain how to analyze and interpret the ratio depending on factors such as a business’ industry.
What Is Asset Turnover?
Asset turnover is a financial ratio that measures a company’s efficiency in utilizing its assets to generate revenue. It is calculated on an annual basis by dividing the total revenue generated by the total value of the business’ assets. Its formula is revenue/average total assets. The significance of an asset turnover ratio differs from industry to industry and comparison is applicable only to companies within the same industry.
Asset turnover is often mistaken for a measure of return on assets. However, it is important to note that asset turnover focuses on revenues only and not on profits. In the most minimal sense, it is a measure of a company’s utility of its full capacity rather than its performance.
Who Uses Asset Turnover?
Virtually every business uses asset turnover ratio in its annual financial calculations. As mentioned earlier, it is a measure of efficacy as well as performance. And although it is not a measure of return on assets, it is still an important ratio of measuring a business’ productivity. It is a vital financial ratio for many individuals in the company including executives and stakeholders.
Investors also use asset turnover ratios when determining the companies’ to invest in. As explained earlier, asset turnover ratio helps determine whether a business it operating to its capacity’s full potential. As such, the ratio is an important estimate of a company’s growth and, thus, a helpful analytical tool for long term investors.
Ways in Which Asset Turnover Ratio Can Help Your Business
Like many other financial ratios, asset turnover ratio is an important analytical tool that if used well, can help a business improve its performance.
It is especially useful to growing businesses in the process of acquiring new assets. It helps to determine whether the cost of growth is sustainable presently and in the long term by comparing present scores with past ones. It is also useful for determining useful and idol assets. The identified idol assets can either be put to use or sold to reduce wastage of resources. In many ways, the asset turnover ratio helps a business identify its internal strengths and weaknesses and react accordingly to improve performance.
The asset turnover ratio is also useful for helping determine a business’ competitive edge based not on income but rather performance. For instance, a small business may utilize its assets better than its bigger competitor. In such cases, the small business poses a threat in the long term as it expands and increases its assets. Businesses also use the asset turnover ratio to woo investors. This depends on the score; a good score is appealing to investors.
Four Tips for Calculating and Applying Asset Turnover Ratio
1. Be comprehensive with your calculations
The asset turnover ratio should be calculated based on the business’ annual balance sheet figures. The previous and present year’s values of total assets should be added and used to divide the present year’s total revenue.
For example, suppose the present year’s total revenue is $100,000 and the past and present year’s total asset values are $50,000 and $100,000 respectively. The asset ratio will be calculated as: $100,000/ ($50,000+$100,000) = 0.66.
2. Categorize the costs of operation
Assets are either labor or capital intensive depending on their nature. These categories are important when calculating the asset turnover ratio as labor-intensive assets are more expensive than capital-intensive assets in the long term.
It is important, however, to note that most businesses regard all assets as one, and categorizing is important only when there is need for refined analysis.
3. Complement the ratio with other financial ratios
Alone, the asset turnover ratio is not sufficient for a comprehensive analysis of a business. As mentioned earlier, the ratio is one of three components of the DuPont Analysis; the other two are profit margin and financial leverage ratios.
Profit margin is a financial ratio used to measure how much a business retains out of every dollar earned. It is calculated by dividing the net income by revenues. Financial leverage ratio, on the other hand, is vital for determining when and how much to borrow or invest into a business.
4. Consider several factors when comparing
For starters, comparison should be limited to companies within the same industry. Additionally, factors such as age and quality of assets should also be factored.
It is also important to remember that a ratio score’s appeal is not determined by its size. A high or low score has differing implications in different industries. For instance, high-profit-margin industries such as the tech industry tend to have lower scores while low-profit-margin industries tend to have higher scores.
Asset turnover is the most common and effective financial ratio for measuring a business’ efficacy in utilizing its assets. It is useful for identifying a business’ internal strengths and weaknesses and, consequently, adapting new tactics of improving performance. It also has several other uses including estimating present and future growth and determining whether or not to invest.
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