Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.
All Kind of Cupcakes opened 2 years ago and has grown into several franchises. With its enormous growth in sales, the company has had to hire several employees to help manage the business.
Jan was hired as the company's chief financial officer, and she brought on a team of analysts to review the company's financial health. She calls a meeting and tells the analysts they will calculate financial ratios and analyze the results. Financial ratios are a combination of two or more line items from financial statements joined by a mathematical operation.
The first financial ratio she mentions is the total asset turnover ratio, which is calculated by taking net sales/total assets. It tells us how efficiently a business is using its assets to generate sales.
For the rest of this lesson, we'll further explore the components of the total asset turnover formula and discuss how to analyze the ratio.
All Kind of Cupcakes only sell cupcakes. You'll find the company's sales, also called revenue, listed on the income statement. The total asset turnover formula shows the numerator as net sales, so what's the difference between sales and net sales? Net sales are simply sales minus any returns or discounts. One of the financial analysts raised his hand and asked, 'Why would someone want to return a cupcake?' Jan responds by explaining, 'A cupcake can be returned if someone is allergic to the ingredients or if the taste wasn't what they expected - good question'. Now let's move on to assets.
Assets are the items owned by All Kind of Cupcakes, such as the bakeries, inventory, land, administrative buildings and cash. Assets are listed on the balance sheet in two categories: current and long-term. Current assets are items that will be used, sold or consumed within a year. From the examples listed above, that would include inventory and cash. Long-term assets are those that may be used, sold or consumed in more than a year, such as the bakeries, land and administrative buildings.
Notice the total asset turnover formula lists the denominator as total assets. To find total assets, you would add current plus long-term assets. Now let's see how the ratio is calculated and analyzed.
If All Kinds of Cupcakes has net sales of $750,000 and total assets of $1,000,000, its total asset turnover is 0.75. In sum, each dollar of assets generates 75 cents in sales. The higher the ratio, the more efficient the company is using its assets to make sales.
Every industry has a different baseline, therefore, it's imperative to compare All Kinds of Cupcakes to the competitors and determine if the company is above or below the industry average. After analysis, one might find that, all in all, 75 cents is a solid number.
Financial ratios are comprised of two or more line items from financial statements joined by a mathematical operation. To calculate the total asset turnover ratio, you take net sales/total assets. The net sales are the numerator, while the total sales are the denominator. The ratio tells us how efficiently we are using our assets to generate sales.
Sales are also called revenue and can be found on the income statement. Net sales are simply sales minus returns and discounts. Assets are items the company owns come in to forms: current and long-term. To find total assets, we would add current and long-term together.
Once you calculate the ratio, it's important to analyze the results. A high ratio shows the company is generating sufficient sales as in relation to its assets. However, a low ratio means the company is not using all of its assets to affect sales. Lastly, it's important to compare the ratio to competitors in the industry to determine a baseline before making a final analysis.
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