The asset turnover ratio is a widely used efficiency ratio that analyzes a company’s capability of generating sales. It accomplishes this by comparing the average total assets to the net sales of a company. Expressly, this ratio displays how efficiently a company can utilize this in an attempt to generate sales.
To be more precise, the total asset turnover ratio calculates net sales as a given percentage of assets, in an attempt to outline how many sales are generated from each asset owned by the company. As an example, in the case of a .5 ratio, every dollar of the asset would facilitate no less than 50 cents of sales.
Understanding the Formula of the Asset Turnover Ratio
So, what is the formula of this ratio? Well, according to the formula, you have to divide the net sales by the average total assets in order to get the asset turnover ratio.
You should find the net sales on the company’s income statement. Essentially, the net sales are primarily utilized for calculating the ratio returns and refunds. The returns and refunds should be withdrawn out of the total sales, in order to accurately measure a firm’s asset capability of generating sales.
Fundamentally, in order to calculate the average total assets, what you have to do is simply add the beginning and ending total asset balances together and divide the result by two. This is just a basic average based on a two-year balance sheet. While there is always the option of utilizing a more in-depth, weighted average calculation, this isn’t mandatory.
Analyzing the Formula of the Asset Turnover Ratio
So, since a ratio outlines the efficacy level of a firm’s ability to use assets for generating sales, it makes sense that a higher ratio is much more favorable. A high turnover ratio points that the company utilizes its assets more effectively. On the other hand, lower ratios highlight that the company might deal with management or production issues.
If a company has an asset turnover ratio of 1, this implies that the net sales of the firm are the same as the average total assets for an entire year. In other words, this would mean that the company generates 1 dollar of sales for every dollar the firm has invested in assets.
Similar to other finance ratios out there, the asset turnover ratio is also evaluated depending on the industry standards. That’s specifically because some given industries utilize assets much more effectively in comparison to others. Therefore, to get an accurate sense of a firm’s efficacy level, it makes sense to compare the numbers with those of other companies that operate in the same industry.
What makes the asset turnover ratio of utmost importance is that it gives creditors and investors a general idea regarding how well a company is managed for producing sales and products. Thus, most analysts utilize this ratio before considering any investment, in order to make a sensible and informed decision.