What is Asset Turnover Ratio?
The asset turnover ratio measures the value of a company's sales or revenues relative to the value of its assets. The asset turnover ratio can be used as an indicator of the efficiency with which a company is using its assets to generate revenue.
The higher the asset turnover ratio, the more efficient a company. Conversely, if a company has a low asset turnover ratio, it indicates it is not efficiently using its assets to generate sales.
The Formula for Asset Turnover Is
Asset Turnover=2Beginning Assets + Ending AssetsTotal Saleswhere:Total Sales=Annual sales totalBeginning Assets=Assets at start of yearEnding Assets=Assets at end of year
Asset Turnover Ratio
What Does the Asset Turnover Ratio Tell You?
The asset turnover ratio is calculated on an annual basis. The total assets number used in the denominator can be calculated by taking the average of assets on the balance sheet at the beginning of the year and at the year's end.
The higher the asset turnover ratio, the better the company is performing, since higher ratios imply that the company is generating more revenue per dollar of assets. The asset turnover ratio tends to be higher for companies in certain sectors than in others. Retail and consumer staples, for example, have relatively small asset bases but have high sales volume – thus, they have the highest average asset turnover ratio. Conversely, firms in sectors such as utilities and real estate have large asset bases and low asset turnover.
Since this ratio can vary widely from one industry to the next, comparing the asset turnover ratios of a retail company and a telecommunications company would not be very productive. Comparisons are only meaningful when they are made for different companies within the same sector.
- Asset turnover is the ratio of total sales or revenue to average assets.
- This metric helps investors understand how effectively companies are using their assets to generate sales.
- Investors use the asset turnover ratio to compare similar companies in the same sector or group.
- It is a tool to see which firms are making the most use of their assets and to identify weaknesses in firms.
Example Using the Asset Turnover Ratio
Let's calculate the asset turnover ratio for four companies in the retail and telecommunication-utilities sectors – Walmart Inc. (NYSE: WMT), Target Corporation (NYSE: TGT), AT&T Inc. (NYSE: T), and Verizon Communications Inc. (NYSE: VZ) – for the fiscal year ended 2016.
AT&T and Verizon have asset turnover ratios of less than one, which is typical for firms in the telecommunications-utilities sector. Since these companies have large asset bases, it is expected that they would slowly turn over their assets through sales. Clearly, it would not make sense to compare the asset turnover ratios for Walmart and AT&T, since they operate in very different industries. But comparing the asset turnover ratios for AT&T and Verizon may provide a better estimate of which company is using assets more efficiently.
For example, from the table, Verizon turns over its assets at a faster rate than AT&T. For every dollar in assets, Walmart generated $2.30 in sales, while Target generated $1.79. 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 could also not be using its assets efficiently: fixed assets such as property or equipment could be sitting idle or not being utilized to their full capacity.
Using the Asset Turnover Ratio with DuPont Analysis
The asset turnover ratio is a key component of DuPont analysis, a system that the DuPont Corporation began using during the 1920s 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:
ROE=Profit Margin(RevenueNet Income)×Asset Turnover(Average AssetsRevenue)×Financial Leverage(Average EquityAverage Assets)
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 Difference Between Asset Turnover and Fixed Asset Turnover
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. This efficiency ratio compares net sales (income statement) to fixed assets (balance sheet) and measures a company's ability to generate net sales from its fixed-asset investments, namely property, plant, and equipment (PP&E). The fixed asset balance is used net of accumulated depreciation. In general, a higher fixed asset turnover ratio indicates that a company has more effectively utilized investment in fixed assets to generate revenue.
Limitations of the Asset Turnover Ratio
While the asset turnover ratio should be used to compare stocks that are similar, this kind of comparison does not provide all 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 check 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. Many other factors (such as seasonality) can affect a company's asset turnover ratio during periods shorter than a year.