The asset turnover ratio measures the efficiency of a company's assets to generate revenue or sales. It compares the dollar amount of sales or revenues to its total assets. The asset turnover ratio calculates the net sales as a percentage of its total assets.
Generally, a higher ratio is favored because there is an implication that the company is efficient in generating sales or revenues. A lower ratio illustrates that a company is not using the assets efficiently and has internal problems. Asset turnover ratios vary throughout different sectors, so only the ratios of companies that are in the same sector should be compared. The ratio is calculated on an annual basis.
In certain sectors, the asset turnover ratio tends to be higher for companies than in others. For example, retail companies have relatively small asset bases combined with high sales volume. This leads to a high average asset turnover ratio. Meanwhile, firms in sectors such as utilities tend to have large asset bases and low asset turnover. Selling off assets to prepare for declining growth has the effect of artificially inflating the ratio. Comparisons carry the most meaning when they are made for different companies within the same sector.
A key component of DuPont analysis is the asset turnover ratio, a system that began being used during the 1920s to evaluate divisional performance across a corporation. Return on equity (ROE) breaks down into three components as the first step of DuPont analysis, one of which is asset turnover, the other two being profit margin and financial leverage.
Calculating the Asset Turnover Ratio
To calculate the asset turnover ratio, divide net sales or revenue by the average total assets. For example, suppose company ABC had total revenue of $10 billion at the end of its fiscal year. Its total assets were $3 billion at the beginning of the fiscal year and $5 billion at the end. The average total assets are: $8 billion ($3 billion + $5 billion) ÷ 2 or $4 billion. Its asset turnover ratio for the fiscal year is 2.5 (that is, $10 billion ÷ $4 billion).
On the other hand, company XYZ, in the same sector as company ABC, had total revenue of $8 billion at the end of the same fiscal year. Its total assets were $1 billion at the beginning of the year and $2 billion at the end. The average total assets are: $3 billion ($1 billion + $2 billion) ÷ 2 or $1.5 billion. Therefore, the asset turnover ratio is 5.33 (that is, $8 billion ÷ $1.5 billion).
After comparing the two asset turnover ratios, company XYZ is more efficient in using its assets to generate revenue than company ABC.
The Bottom Line
The asset turnover ratio helps investors understand how effectively companies are using their assets to generate sales. Investors use this ratio to compare similar companies in the same sector or group to determine who's getting the most out of their assets and to identify help identify weaknesses. The asset turnover ratio is calculated by dividing net sales or revenue by the average total assets.