The asset turnover ratio is the percentage of a company’s revenue to the value of its average total short- and long-term assets. It measures how efficient a company is at using its assets to generate revenue. For example, if your net sales are $20,000 and average total assets are $12,000, then your asset turnover ratio is 1.67.
Asset Turnover Ratio Formula
The asset turnover ratio is relatively simple to calculate. All you have to do is divide your net sales by your average total assets.
Below is the asset turnover ratio formula:
Asset Turnover Ratio = (Net Sales) / (Average Total Assets)
Asset Turnover Ratio Example
Let’s now look at each component of the asset turnover ratio below. This will give you a good understanding regarding how to calculate net sales, average total assets, as well as your overall asset turnover ratio.
Net sales represent the amount of sales generated by a company after the cost of returns, allowances for damaged or missing goods, and discounts are deducted. The net sales of a company provides a more accurate figure when compared to the gross sales generated by the business.
For example, if your company has gross sales of $100,000, sales returns of $2,000, sales allowances of $3,000, and total discounts of $5,000, your net sales are as follows:
$100,000 – $2,000 – $3,000 – $5,000 = $90,000
Average Total Assets
Average total assets represents the average value of both short- and long-term assets recorded on a company’s balance sheet over the past two years. To calculate average total assets, simply add the ending value of your total assets from the previous year to the value of your total assets from the current year, and divide the sum by two.
For instance, if your company’s total asset balance at the end of 2016 is $60,000 and the current balance for 2017 is $45,500, the average total assets is calculated as follows:
($60,000 + $45,500) / 2 = $52,750
Now that you have both of these values, the next step is to divide net sales by average total assets to get your asset turnover ratio. Using the example above, if you have $90,000 in sales and $52,750 in average total assets, your net working capital ratio will be:
($90,000 / ($52,750) = 1.7
Why is the Asset Turnover Ratio Important?
The asset turnover ratio is important because it shows how efficient a company is at using its assets to generate sales. Businesses typically monitor the asset turnover ratio to help strategize ways to improve revenue by utilizing new and existing assets. This ratio is also used by external stakeholders like creditors and investors when assessing a company’s management team.
While the current ratio and the quick ratio are considered “bad” when they go over 2, the asset turnover ratio is typically better the higher it is because it shows you’re getting more revenue out of your existing assets. This means that a business’s assets are being invested wisely and not being left idle. Conversely, a lower ratio typically means that a company has unused assets that have the ability to generate revenue, but aren’t.
How to Improve the Asset Turnover Ratio
Low asset turnover can be a result of slow sales, uncollected invoices, or a problem with production and inventory management. In order to increase a business’s asset turnover ratio, strategic planning is required to increase the business’s productivity and efficiency.
Here are 7 ways to improve a company’s asset turnover ratio:
1. Increase Sales
The most obvious way to improve the asset turnover ratio is to find ways to increase sales. Often, a low asset turnover ratio is simply the result of a lack of ability to generate sales. When increasing sales, start by trying to increase the average basket size with existing customers, and then find new consumer segments to onboard as customers. You can also increase your product line but this might increase your assets, having a net zero or net negative effect.
2. Manage Inventory
Too much inventory is a common reason why a company has a low asset turnover ratio. This is because inventory is a somewhat illiquid current asset that can sit on your books for a long time.
Learn to forecast your sales and get the right amount of inventory so that you’re able to keep up with demand without having too much of it on hand.
3. Liquidate Old or Unused Assets
Unused and obsolete assets can be liquidated immediately in return for cash that can be invested elsewhere to generate revenue. If you have equipment that isn’t used, consider renting or selling it and use the cash to invest in areas that can quickly increase your revenue.
Remember that cash is also an asset, so you’ll need to invest it in income-producing activities to increase your asset turnover ratio.
4. Lease Long-Term Assets
Instead of buying fixed assets such as equipment and/or machinery, consider leasing the equipment or machinery. Leased equipment is not counted as a fixed asset on your balance sheet. Further, if you lease long-term assets, you can upgrade them after your lease term without having to retain the depreciated value on your books or having to think about ways to dispose of them.
5. Improve Invoice Collection
If your company’s average total assets are made up of outstanding and overdue invoices, then improving invoice collection is key to improving your asset turnover ratio. You can do this by adjusting your invoice terms (like reducing the collection period of receivables) or hiring a collection agency to collect on delinquent accounts.
However, this only applies to companies that report on a cash basis. If you report on the accrual basis, this will have no effect on your asset turnover since you would’ve already recognized the revenue.
6. Sell High Margin Products and Services
Products and services with high margins can result in comparatively higher net sales compared to the assets used to generate those sales. If you’re able to sell higher margin products or services, there’s a good chance you can increase your profitability, and therefore, your asset turnover ratio.
7. Take Advantage of Economies of Scale
Another way to improve your asset turnover ratio is to rely on large stores and warehouses and take advantage of economies of scale. This can reduce the costs of producing, delivering, and selling your products or services, thus increase net profits and your asset turnover ratio. Also, carefully maintain your store or warehouse equipment to minimize downtime and unit costs.
The asset turnover ratio is a good way to measure the efficiency of your business. It shows how well your company is using its assets to generate revenues. It is recommended to monitor your asset turnover ratio regularly because it can help with business planning and also help boost revenue and profitability.