Comparisons are only meaningful when they are made for different companies within the same sector. Let's calculate the asset turnover ratio for four companies in the retail and telecommunication-utilities sectors—Walmart Inc. Since these companies have large asset bases, it is expected that they would slowly turn over their assets through sales. Target's turnover may indicate that the retail company was experiencing sluggish sales or holding obsolete inventory.
Furthermore, its low turnover may also mean that the company has lax collection methods. The firm's collection period may be too long, leading to higher accounts receivable. Target, Inc. The asset turnover ratio is a key component of DuPont analysis , a system that the DuPont Corporation began using during the s to evaluate performance across corporate divisions.
The first step of DuPont analysis breaks down return on equity ROE into three components, one of which is asset turnover, the other two being profit margin, and financial leverage. The first step of DuPont analysis can be illustrated as follows:. Sometimes, investors and analysts are more interested in measuring how quickly a company turns its fixed assets or current assets into sales. In these cases, the analyst can use specific ratios, such as the fixed-asset turnover ratio or the working capital ratio to calculate the efficiency of these asset classes.
The working capital ratio measures how well a company uses its financing from working capital to generate sales or revenue. While the asset turnover ratio considers average total assets in the denominator, the fixed asset turnover ratio looks at only fixed assets. The fixed asset turnover ratio FAT is, in general, used by analysts to measure operating performance. The fixed asset balance is used net of accumulated depreciation.
Depreciation is the allocation of the cost of a fixed asset, which is spread out—or expensed—each year throughout the asset's useful life.
Typically, a higher fixed asset turnover ratio indicates that a company has more effectively utilized its investment in fixed assets to generate revenue. While the asset turnover ratio should be used to compare stocks that are similar, the metric does not provide all of the detail that would be helpful for stock analysis.
It is possible that a company's asset turnover ratio in any single year differs substantially from previous or subsequent years. Investors should review the trend in the asset turnover ratio over time to determine whether asset usage is improving or deteriorating.
The asset turnover ratio may be artificially deflated when a company makes large asset purchases in anticipation of higher growth. Likewise, selling off assets to prepare for declining growth will artificially inflate the ratio.
Also, many other factors such as seasonality can affect a company's asset turnover ratio during periods shorter than a year. The asset turnover ratio measures the efficiency of a company's assets in generating revenue or sales.
It compares the dollar amount of sales revenues to its total assets as an annualized percentage. Thus, to calculate the asset turnover ratio, divide net sales or revenue by the average total assets.
One variation on this metric considers only a company's fixed assets the FAT ratio instead of total assets. Generally, a higher ratio is favored because it implies that the company is efficient in generating sales or revenues from its asset base.
A lower ratio indicates that a company is not using its assets efficiently and may have internal problems. Asset turnover ratios vary across different industry sectors, so only the ratios of companies that are in the same sector should be compared.
For example, retail or service sector companies have relatively small asset bases combined with high sales volume. This leads to a high average asset turnover ratio. Meanwhile, firms in sectors like utilities or manufacturing tend to have large asset bases, which translates to lower asset turnover. A company may attempt to raise a low asset turnover ratio by stocking its shelves with highly salable items, replenishing inventory only when necessary, and augmenting its hours of operation to increase customer foot traffic and spike sales.
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Part 2. Find your return on assets. Asset turnover is not the only way to calculate asset utilization. Another common measure of roughly the same performance metric is known as return on assets. This ratio compares net income, rather than sales, to total assets. Net income represents the company's profit their "bottom line" over the period. Calculate accounts receivable turnover. Accounts receivable turnover is another financial ratio that measures how effective the business is at collecting money it is owed.
Net credit sales are all sales made on credit minus any returns, discounts, or allowances for damaged or lost goods. Convert your result to the average collection period. After calculating accounts receivable turnover, you can easily find the average collection period.
This represents how long, on average, an amount stays in the accounts receivable account before being collected. A long collection period may mean that the business is susceptible to cash flow shortages. Determine inventory turnover. Another way to measure asset utilization is to look at how well a business manages its inventory. This can be done by calculating inventory turnover. Cost of goods sold can be found on a business's income statement. A small inventory turnover means that the company stores inventory for a longer period of time.
This, in turn, increases storage costs and can mean lost sales opportunities. Find the average age of inventory. This is simply another way of looking at inventory turnover.
Like all other ratios, this one can be compared to its historical values over time for the business or to the same ratio for a competing business.
Part 3. Analyze your result. In general, asset utilization is a measure of how well a business is able to utilize their assets to produce revenue. A relatively high ratio means that the company is efficient in using their assets, whereas a low one may indicate poor asset management.
How high a specific business's asset utilization ratio should be depends on its industry and stage in its lifecycle. From another angle, a low asset utilization ratio may indicate over-investment in assets.
Compare the result to that of competing companies. Asset turnover is most commonly used to compare the performance of one business or company to that of a competitor or the industry average. Because of operational differences, comparing asset turnover for businesses in different industries does not provide for an accurate comparison. Look for industry asset turnover averages in industry publications or use financial statements from a competing company to obtain figures that you can compare your asset turnover to.
Asset turnover averages vary widely between industries. Whereas retail companies may have asset turnovers well over 2.
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