What do you mean by the asset turnover ratio?
The Asset Turnover Ratio is an asset management ratio. It measures the ability to produce sales from available assets of the company with the help of net sales and average total assets.
In other languages, to get an asset turnover ratio, divide the net sales by average total assets.
Here, to get net sales to deduct sales returns, sales discount, sales allowance from gross sales. When adding the opening or beginning assets and closing value of the assets of the current fiscal year and divide them by 2, get average total assets.
Due to its nature to checks and presents the efficiency and activity of the company, also known as efficiency ratio or activity ratio.
In simple words, it checks how efficiently a company using its assets to penetrate the sales.
This ratio helps to judge the efficient utilization of each dollar of assets to generate an optimum dollar of sales.
Generally, this ratio recommends the high value because that high value shows a company is generating optimum utilization of its assets by penetrating its optimized sales.
Advantage of Asset Turnover Ratio
- It provides a better view compared to the sales figure.
- A higher value of this ratio shows the better management of the company.
- A higher value means higher utilization of assets.
- It concerns sales penetrations.
- A better ratio figure shows a view to the investors to invest in that particular company.
- Due to the efficient utilization of assets, popularly called efficiency ratio.
- It checks how efficiently a company using its assets to penetrate the sales.
Disadvantage of Asset Turnover Ratio
- It includes all the assets as well as ideal assets that must not be included.
- It’s only applied for general assets.
- This ratio is unable to extract individual asset utilization.
- It limits the understanding of investors about exact individual utilization.
- Only concentrates on the optimization of sales figure not on profit figures.
The formula of Asset Turnover Ratio
The asset turnover ratio formula is a part of the ratio analysis chapter. Now what we are supposed to learn over here is one bit of portion or a slice of the ratio analysis which is your asset turnover ratio.
The formula which is basically because it’s a turnover ratio the sales have to come up it’s the net sales because you are considering the percentage of the total assets over here.
It’s the assets ratio over here as such turnover ratio so net sales divided by the average total assets.
Now let’s understand this formula now what is this formula all about see your asset turnover ratio is basically your efficiency ratio that judges how efficiently a company uses its assets to generate sales.
I mean revenue so here the asset ratio formula will go something like this your asset turnover ratio is equal to your net sales divided by your average total assets.
So this is going to be your formula now the asset turnover ratio formula example.
Example of Asset Turnover Ratio
Now let’s take a practical example of an asset turnover ratio so as to get some more insight on this now there is a company that’s called ABC Company which has gross sales which have a gross sales standing at $75,000 and at this is at the end of 2020.
I am talking about but the sales return and with the help of which you will receive your net sales so this is just your crossings as you can see above let’s say your sales are done is $5,000.
And the total assets let’s say the total assets at the beginning of the is let’s say $1,20,000 in the year 2020. Itself lets at the beginning of 2020 your reconsider is as a calendar you and at the end of the total assets.
Let me just define this is total assets at beginning expand this and we’ll say the next thing as a total asset at the end so the total assets let’s say at the end is let’s say $1,60,000 in the year 2020.
So based on this we need to find the asset turnover ratio of ABC Company. First of all, we need to calculate is the net sales.
So I’ll just write the answer part what we need to find is the net sales for so one net sale is going to be our gross sales less our sales it.
So that’s going to be our net since remembering you need to deduct any sales return discount if any now we will calculate the average total assets by using the simple average method.
Now the total assets at the beginning of the year as you can see is $1,20,000 the average for the total assets at the end is $1,60,000.
So the average is going to be we need to open the bracket 1,20,000 + 1,60,000 we need to divide this thing by 2 i.e.
Average Total Assets = ($1,20,000 + $1,60,000)/2 = $1,40,000
So we get an average total asset of 1,40,000.
Now let’s calculate net sales by subtracting from gross sales to sales returns i.e.
Above formula and net sales value as follows:
Net Sales = $75,000 – $5,000 = $70,000
Now, we have,
Net Sales = $70,000
Average Total Assets as $1,40,000 and put these value to this formula, we get,
Asset Turnover Ratio = $70,000 / $1,40,000 = 0.5
You get 0.5 so 0.5 is basically your answer.
Interpretation and Analysis of Asset Turnover Ratio
If you compare the asset turnover ratio of let’s say ABC company with the asset turnover ratio of similar companies under the same industry but we would be able to tell 0.5 is a really good number or exactly not.
Now we will need to understand the explanation part of the asset turnover ratio formula. See the asset turnover ratio formula is complete; you can see the opposite of the asset to sales the ratio remember this thing in this ratio.
We look at the net sales and the average total assets so in the income statement in the income statement, you will find your gross sales. You’ll find what crossings and will get based on this the net sales after getting the data of the sales returns.
On the other hand, if you want to find the total assets. I am talking about the total assets over here. If you want to find the total assets data then for the same we need to look at the assets that are at the beginning of you’re right.
That’s first would the beginning of the year and the assets that are at the end of the year and then we can take the average of the assets at the beginning.
In the end, remember one thing in the case of the net sales we need to read out anything that is related to sales discount if any in the due course.
You also need to deduct sales return from this from the gross sales so have to receive your net sales. Now if we want to go deep we can use them for this in this particular case we are using over yours.
The simple average now if you want to go a little bit deeper in this then we can absolutely go for the WAM.
The WAM method which is also known as your weighted average method. Okay now what exactly is the use over here what the use of the asset turnover ratio is?
The value of the asset turnover ratio is higher than 1 is good. Remember one thing this ratio is better only if the ratio is higher.
Now why this is a big question why exactly see if the asset turnover ratio if it is more it indicates that the asset of the company is. You can say they have been properly utilized by the company and that do you can see efficiently.
If the value of the ratio is less 1 then you can say the assets are not properly utilized and the assets are not being efficiently employed in the company.
You can understand from the result of this ratio from the above-mentioned example. Here ATR of ABC company is 0.5 means that the net sales are 50% right of the average of the total assets.
Now if your average total assets ratio is let’s say 1 then the net sales are can take as 100% of the average total assets.
When a company let’s say buys new machinery then the company can produce more products and sell out more products as well as a result of the revenue of the company.
You can see the revenue of the company increases along the way, however, you know if installing new pieces of machinery doesn’t result to increase in the sales that means either the pieces of machinery you can say defective or the company isn’t able to you can say utilize the assets properly.
So you must check the performance with the help of this ratio this out at the end of the day what you need to use this for is to make your own interpretation by you know punching few numbers here and thereby changing few details and you know you will see amazing results out of the same.
Let’s say if you put your net sales as 1 million and your average total assets as 2 million that means it’s 0.5 X the more variable thing it is the net sales and not the average total assets so let’s change this to 2 million.
Absolutely, this will be at the increased price that is a 10x so the net change is going to increase as the net sales increase. Your ratio also increases but as your net sales basically decrease your ratio also decreases.
We are assuming that the total assets are remaining the same because they have very little change over even if they have can be handled.
So utilize the ratio and do the proper analysis of your business and make sure your available means and tools are utilized efficiently and effectively to generate optimum sales to get optimum profit from these assets.
Best of Luck