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 The returns and refunds should be withdrawn out of the total sales, in order to accurately measure a firm’s asset capability of generating sales.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.
Let’s say that XYZ Corp has net sales of $5,000,000. Its total assets at the start of the year were $2,000,000 and at the end of the year were $3,000,000.
The average total assets would be: ($2,000,000 + $3,000,000) / 2 = $2,500,000
The Asset Turnover Ratio would be: $5,000,000 / $2,500,000 = 2
This means that for every dollar of assets, XYZ Corp generated $2 in sales.
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.
How can OKRs help with the Asset Turnover Ratio?
OKRs can be instrumental in improving a company’s Asset Turnover Ratio. They help set clear, measurable goals focused on optimizing asset use for revenue generation. The strategic alignment provided by OKRs facilitates decision-making and actions that directly contribute to an improved Asset Turnover Ratio.
OKR Example with Key Result and Initiatives
Objective: Improve the company’s asset efficiency
Key Result 1: Increase the Asset Turnover Ratio from 2 to 2.5 by the end of Q4
- Implement a robust inventory management system to reduce the holding period of stocks.
- Accelerate the accounts receivable collection process.
- Invest in machinery and equipment that will increase production capacity.
Key Result 2: Reduce average collection period for accounts receivable from 45 days to 30 days by the end of Q4.
- Implement an efficient digital invoicing system to speed up the billing process.
- Offer incentives for early payments to encourage customers to pay their invoices ahead of time.
- Improve communication with customers about their billing details and due dates to avoid any misunderstandings or delays.
Key Result 3: Decrease inventory holding period from 60 days to 45 days by the end of Q4.
- Adopt a Just-in-Time (JIT) inventory system to reduce the amount of time inventory is kept in stock.
- Improve supplier relationships to ensure timely delivery of materials, reducing the need for large inventory buffers.
- Regularly review and update the inventory forecasting models to avoid overstocking or under stocking.
1. What is a good asset turnover ratio?
The answer to this can vary by industry, but in general, a higher asset turnover ratio indicates a more efficient business.
2. What does a low asset turnover ratio mean?
A low asset turnover ratio suggests that a company is not using its assets efficiently to generate sales.
Benchmark Against Industry Standards
It’s important to compare your asset turnover ratio with industry peers. This provides context for your ratio and can highlight areas for improvement.
Track Over Time
Trends can provide more insight than a standalone number. If your asset turnover ratio is improving over time, you’re likely becoming more efficient.
Balance Efficiency and Quality
While it’s important to use assets efficiently, this shouldn’t come at the cost of product or service quality. It’s important to strike a balance between these two factors.
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.