What is the Asset Turnover Ratio?
The Asset Turnover Ratio is a metric that measures the efficiency at which a company utilizes its asset base to generate sales.
If management’s operating capital spending has been inefficient, the company is most likely losing out on potential sales due to the misallocation of capital, which will eventually show up on its financials via lower profitability and free cash flow.
- What does the asset turnover ratio measure?
- How does the total asset turnover differ from the fixed asset turnover?
- Which factors impact the asset turnover ratio of a company?
- What is considered a “good” or “bad” asset turnover ratio?
In This Article
Asset Turnover Explained
Generally speaking, the higher the asset turnover ratio, the better, as this suggests that the company is producing more sales per dollar of asset owned (i.e., faster conversion into turnover, or revenue), and is an indication of being better at putting its assets to use.
The asset turnover metric falls short, however, as it is distorted by significant one-time capital expenditures and asset sales.
Whether you are assessing another company’s financials or attempting to determine the right amount of capital to allocate for your business, you can obtain the most useful information by comparing your company’s asset turnover ratio to that of industry peers.
Additionally, you can track how your investments into ordering new assets have performed year-over-year to see if the decisions paid off or require adjustments going forward.
Asset Turnover Formula
Unless specified otherwise, the asset turnover ratio answers the question, “How much in revenue does the company generate per dollar of assets owned?”
For instance, if the total asset turnover ratio of a company is 1.0x, that would mean the company’s net sales are equivalent to the average total assets in the period. In other words, this company is generating $1.00 of sales for each dollar invested into all assets.
The formula used to calculate the total asset turnover divides the net sales of a company by the average balance of the total assets belonging to the company (i.e., the average between the beginning and end of period asset balances).
Recall from accounting that while the income statement measures a metric across two periods, balance sheet items reflect values at a certain point time. We use the average total assets across the measured net sales period in order to align the timing between both metrics.
Another commonly tracked metric is the fixed asset turnover. The key difference is that only long-term fixed assets (PP&E) are included in the calculation, as opposed to all assets.
As shown in the formula below, the fixed asset turnover is the ratio between the net sales of a company relative to the value of its fixed assets. It is often used as a proxy for how efficiently a company has invested into long-term assets.
The fixed asset turnover ratio is meant to isolate how efficiently the company uses its fixed asset base to generate sales (i.e., capital expenditures). Considering how costly the initial purchase of PP&E and maintenance can be, each spending decision towards these long-term investments should be made carefully to lower the chance of creating operating inefficiencies.
Interpreting the Asset Turnover Ratio
Regardless of whether the total or fixed asset turnover ratio is used, the metric does not say much by itself without a point of reference. In practice, the ratio is most helpful when compared to that of industry peers and tracking how the ratio has trended over time.
- Low Asset Turnover Ratio ➝ Often indicates excess production capacity or inefficient inventory management
- High Asset Turnover Ratio ➝ Suggests the company is allocating capital and deriving more benefits from its assets
Comparisons of the asset turnover ratios are going to be most meaningful amongst companies within the same vertical/industry, and setting the parameters to determine what should be considered “high” or “low” ratios should be made within a specific industry context.
The average asset turnover ratios are going to vary significantly across different sectors, so it makes the most sense for only ratios of companies in the same or comparable sectors to be benchmarked.
Over time, positive increases in the asset turnover ratio can serve as an indication that a company is gradually expanding into its capacity as it matures (and the reverse for decreases across time). All companies should strive to maximize the benefits received from their assets on hand, which tends to coincide with the objective of minimizing any operating waste.
On the flip side, an asset turnover ratio far exceeding the industry norm could be an indication that the company should be spending more and might be falling behind in terms of development.
Thus, a sustainable balance must be struck between being efficient while also spending enough to be at the forefront of any new industry shifts.
As with all financial ratios, a closer look is necessary to understand the company-specific factors that can impact the ratio. And such ratios should be viewed as indicators of internal or competitive advantages (e.g., management asset management) rather than being interpreted at face value without further inquiry.
For example, a company may have made significant asset purchases in anticipation of coming growth or have gotten rid of non-core assets in anticipation of stagnating or declining growth – and either change could artificially increase or decrease the asset turnover ratio.
Another consideration when evaluating the asset turnover ratio is how capital-intensive the industry that the company operates in is (i.e., asset-heavy or asset-lite). Companies with fewer assets on their balance sheet (e.g., software companies) will typically have higher asset turnover ratios than companies with business models that require significant spending on assets.
Excel Template Download
Now, let’s go through an example to calculate an example company’s total and fixed asset turnover ratios. To follow along, fill out the form below to get access to the file.
Asset Turnover Example Calculation
In our hypothetical scenario, the company has net sales of $250m, which is anticipated to increase by $50m each year. Moreover, the company has three types of current assets (cash & cash equivalents, accounts receivable, and inventory) with the following balances as of Year 0.
- Cash & Cash Equivalents = $15m
- Accounts Receivable = $20m
- Inventory = $25m
For the entire forecast, each of the current assets will increase by $2m. As a quick example, the company A/R balance will grow from $20m in Year 0 to $30m by the end of Year 5.
For the final step in listing out our assumptions, the company has a PP&E balance of $85m in Year 0, which is expected to increase by $5m each period and reach $110m by the end of the forecast period.
We now have all of the required inputs to calculate the total asset turnover ratio, which takes the net sales for the current period and divides it by the average asset balance of the prior and current periods.
To calculate the total asset turnover ratio in Year 1, we’ll divide Year 1 sales ($300m) by the average between the Year 0 and Year 1 total asset balances ($145m and $156m). Upon doing so, we get 2.0x for the total asset turnover.
Once this same process is done for each year, we can move onto the fixed asset turnover.
This time around, we’ll only use the value of the fixed assets in the denominator. For Year 1, we’ll divide Year 1 sales ($300m) by the average between the Year 0 and Year 1 PP&E balances ($85m and $90m), which comes out to a fixed asset turnover of 3.4x.
A screenshot of the completed output from our simple exercise has been posted below.
Considering that the total turnover ratio increased from 2.0x in Year 1 to 2.6x in Year 5 while the fixed turnover ratio increased from 3.4x to 4.7x during the same time horizon, these positive trends could be interpreted as the company using its assets more efficiently over time.
However, for a more practical assessment, data surrounding industry peers is required, as well as the specific details regarding the company’s asset management plans and recent operating changes.