Asset Turnover Ratio can be defined as the value of sales generated for every rupee invested in assets for a given financial year. It is used to measure a firm’s efficiency.
Formula of Asset Turnover Ratio
Asset Turnover Ratio = Total Sales / Average Investment in Assets
Total sales figure can be obtained from the income statement. This is the revenue generated from sales for a given financial year.
Average investments in assets can be obtained from the balance sheet. It is given by:
Average Investments = (Assets at the Beginning of the Period + Assets at the end of the Period)/2
Example Explaining Asset Turnover Ratio
Let us assume a company X. For FY 2010-11, it generated sales of 10 Millions. On the other hand, it had assets worth 1 at the beginning of the period. Towards the end of the period, its assets were 2 Millions.
From the given information, we can deduce Asset Turnover Ratio as follows:
Total sales = 10 Millions
Assets at the beginning of the period = 1 Million
Assets at the end of the period = 2 Millions
Average Investment = (1+2)/2
Average Investment = 1.5 Millions
Thus, Asset Turnover Ratio = 10 Millions / 1.5 Millions
= 6.67 Times
Analysis and Interpretation of ATR
What this means is that, for every $ that the company invests in assets, it generates sales of 6.67. Higher is this figure, better is the management of the company. This is because ideally a company wants to maximize its returns for every investment it makes. If the investment made does not get translated to increase improvement in top-line, and thereby improvement in bottom-line, there is some problem with the decisions taken by management.
Consider two companies X and Y, one with Asset Turnover Ratio of 6.67 and another with Asset Turnover Ratio of 3 respectively. Based on these numbers only, company X has made better investment decisions as compared to company Y.
Advantages of Asset Turnover Ratio
One of the primitive ratios used to measure a company’s performance is the sales generated. Higher the sales better is the company. But this may not give a true picture. Company X may have sales of 10 Millions and Y may have sales of 20 Millions. X may have invested 1 Million on assets, and hence its ATR is 10. Y may have invested 5 Million. So, it’s ATR is 4. Thus, although Y has double the sales, it still may not be as efficient as X because it’s investment fetches 4 times sales, whereas X’s investment fetches 10 times sales. Thus, ATR may give you a better view as compared to the sales figure.
Generally, it is observed that companies with low-profit margins have higher Asset Turnover Ratio. This is because low-margin companies tend to focus more on volume rather than per unit profit. Hence, they use their investments more rigorously.
Disadvantages of Asset Turnover Ratio
ATR does not measure how well a company is earning profits. It only measures how well a company is generating sales. Higher sales may or may not get translated to increase in profits. This is where ATR differs from Return on Assets (ROE).
It is always advisable to compare ATRs of companies within the same sector. Also, ATR on its own may not be a holistic ratio. It must be used in combination with various other ratios to get a better picture of the functioning of a company.