Asset Turnover Ratio Defined
Every business has assets, or things that the company owns and uses in its business in order to make money. These assets can include not just tangible items like cash, supplies, buildings, and equipment, but also intangible assets like trademarks and copyrights. The asset turnover ratio is a number that shows how much revenue is being earned for every dollar the company has spent on assets. It represents how well a company uses its assets to make money.
The formula for figuring the asset turnover ratio is:
To see how to use this formula, let's look at the example of a company that makes jewelry. We'll call it Linda's Jewelry, and Linda is the owner. To make her jewelry Linda needs tools like beads, wire, string, glue, and work tables. She will also need computers and software to keep track of sales, inventory, and other administrative items. All of these items are considered to be assets.
Let's say the company just started in 2013 and had $16,100 worth of total assets in its first year. Since the company has only been in business for one year, we can use the total assets listed on the balance sheet as the average total assets.
Average Total Assets for 2013 = $16,100
If the company has been in operation for at least two years, you will need to calculate the average of the total assets for the past two years. Let's say that in its second year of operation, Linda's Jewelry had $20,000 in assets.
To calculate the average total assets, add the total assets for the current year to the total assets for the previous year,and divide by two.
Average Total Assets for 2014 = (Assets for 2014 + Assets for 2013) / 2
Average Total Assets for 2014 = ($20,000 + $16,100) / 2
Average Total Assets for 2014 = $18,050
Now that we have figured out the average total assets, we can use it in the formula.
The second piece of information that we need for the formula is the company's net revenue, which is the sales revenue after deducting various expenses. Net revenue is taken directly from the income statement. The net revenue used in the formula is generally called total revenue on the income statement. Let's say that in its first year Linda's Jewelry earns $35,000 in net revenue. In the second year, Linda's Jewelry earns $65,000 in net revenue.
Now, let's say Linda wants to understand how well the assets the company has purchased are contributing to creating that income. She would calculate the company's asset turnover ratio to find out. So, for Linda's Jewelry:
Asset Turnover Ratio for 2013 = $35,000 / $16,100
Asset Turnover Ratio for 2013 = 2.14
Asset Turnover Ratio for 2014 = $65,000 / $18,050
Asset Turnover Ratio for 2014 = 3.60
Interpreting Asset Turnover Ratio
The asset turnover ratio of a company is a good way to gauge how a company's assets are contributing to or detracting from its revenue. Generally, the higher the asset turnover ratio the better the company is using its assets; however, exactly what ratio is considered good depends upon the industry. You wouldn't compare a jewelry company's asset turnover ratio to that of a car rental company!
Looking at the example of Linda's Jewelry, we see that in its first year Linda's Jewelry earned $2.17 in sales revenue for every $1 spent on assets, and in the second year, the company increased its efficiency to earn $3.60 per $1 spent on assets. While the ratios for Linda's Jewelry company may seem positive, we would need to compare this number to the asset turnover ratio of other companies in the jewelry industry to be sure. If the average jewelry company was earning $1.50 in sales revenue for every $1 spent on assets, Linda's Jewelry would be doing very well; on the other hand, if the average jewelry company earned $4.80 in sales revenue for every $1 spent on assets, Linda would need to look for ways to manage her assets better.
You can look up the financial statements of other companies in your industry to obtain the information needed for the asset turnover ratio formula and then calculate it yourself.
Let's review. The asset turnover ratio determines how much money a company is making for every dollar that it spends on its assets, or the equipment that a company owns and utilizes in order to function. The formula for asset turnover ratio is this:
Net revenue is taken directly from the income statement, while total assets is taken from the balance sheet. If a company is in operation for more than one year, the average of the assets for each year must be calculated.
Generally, when a company has a higher asset turnover ratio than in years prior, it is using its assets well to generate sales. However, a company must compare its asset turnover ratio to other companies in the same industry for a more realistic assessment of how well it's doing.
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Calculation Of The Asset Turnover Ratio: A Business Case
You will be asked to compute the asset turnover ratio by using the formula provided in the Lesson and the information in the business case below. You will then be asked to interpret the ratio's meaning. The objective of this practice case is to assess your ability to (1) compute the asset turnover ratio and (2) interpret the ratio.
Business Case: Somatel Foods
Somatel Foods is a company based in New York, NY. The company operates a small grocery store in a busy Manhattan neighborhood. Below is some selected information from its latest financial statements.
|Item||Current year ($)||Prior year ($)|
|Sales returns and allowances (Contra Revenue Account)||23,000||47,000|
Calculate the Asset turnover ratio for the current year using the information provided above. (Hint: Be sure to calculate Net Revenue first!)
Somatel has hired consultants to assess its performance relative to its peers. Researchers found that the average grocery food store in Manhattan had an Asset Turnover Ratio of 2.01 in the current year. Using this information, comment on how Somatel Foods is performing relative to its competitors. Is Somatel Foods more effective at generating income from its assets?
=Net revenue / Average assets
Somatel's asset turnover ratio is BELOW the industry average. This means that the company is less effective at generating income from its assets and thus should try to optimize its revenue cycle.
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