Using the asset turnover ratio to improve your business
Whether you’re buying laptops or stocking up on inventory, every dollar you spend for your business should deliver a return on investment (ROI). You can assess how well these expenses are helping your business generate revenue and improve profits by calculating your asset turnover ratio.
Samuel Sponem, Professor and CPA International Research Chair in Management Control at HEC Montréal, says the asset turnover ratio tells you one simple thing about your business: “It verifies how well you are using your production capacity and making efficient use of your assets.”
What is the asset turnover ratio?
The asset turnover ratio is a financial ratio used to measure a company's efficiency in generating revenue from its assets.
It indicates how much revenue your business is generating for every dollar invested in total assets.
Thus, if your business has revenues of $100,000 and total assets of $50,000, the asset utilization ratio will be 2:1. That means your operations generate $2 in revenues for every $1 you have in assets.
How do you calculate the asset turnover ratio?
To work out your ratio, divide your business’s net sales by its total assets.
Net sales (or revenues)
(Your net sales are your gross sales less any returns, discounts or allowances, while your total assets are equal to your equity minus any liabilities.)
For example, suppose your business made $750,000 in net sales last year and had total assets worth $1,500,000.
Using the above formula, we can calculate the asset turnover ratio as follows:
Net sales = $750,000
Total assets = $1,500,000
Asset turnover ratio = 0.5
In other words, every $1 in assets generated 50 cents in net sales revenue.
What is a good asset turnover ratio?
As a general rule, a higher ratio is favourable because it indicates that the company is using its assets efficiently. A lower ratio can indicate inefficiency, which could be due to a poor use of assets, ineffective collection methods, weak inventory management or other issues.
However, acceptable ratios will vary across industries, and correspond to your business’s operating environment and size. For example, a construction business requires far more significant assets—consider all the expensive machinery needed—than a service-oriented business, like an accounting firm.
As a result, sales per asset, meaning the dollar figure of the sales divided by the dollar figure spent on the asset, will be lower in the construction business. That’s perfectly normal, says Sponem.
Because of variables like high-cost machinery, you need to figure out how your business is performing relative to competitors. This would involve finding out what a typical asset turnover ratio is for a business of your size in your industry.
Benchmarking your business’s asset turnover ratio
How do you find out what a competitor’s asset turnover ratio is? Having access to other businesses’ financial statements would allow you to calculate their ratios yourself, but that’s going to be tricky unless your competitors are public companies.
Sponem suggests asking your accountant or banker for comparisons. These finance professionals often have access to private datasets they can use to benchmark your business.
Another meaningful comparison you can make—even without access to competitors’ ratios—is to look at your own ratio today versus other time periods. Think of it as a continuous effort to achieve a personal best.
“The evolution of the indicator over time can reveal whether or not you’re getting better at using your assets efficiently,” says Sponem, who suggests recording your ratio at regular (such as yearly) intervals.
What information isn’t included in the asset turnover ratio?
Keep in mind that, like any financial indicator, the asset turnover ratio in isolation does not give you a complete picture.
For example, you might have old, depreciated assets (equipment) that will soon need replacing. In that scenario, your assets aren’t costing much today, but your revenues might still be high—so your asset turnover ratio will seem favourable. But maybe not for long: If you have to replace all that equipment next year, the number will certainly drop.
“Even though you haven’t done anything, the lower value of your assets improves your ratio—yet it’s not necessarily good for your business,” says Sponem. “Eventually, you will have a problem.”
Conversely, a ratio below the industry benchmark could be explained by an important investment you’ve recently made—such as buying new technology—that will increase your revenues in the near future.
To add value to what the ratio is telling you, look at some non-financial indicators, says Sponem. For example, you could use and monitor key performance indicators (KPIs) such as revenue growth, throughput, the value of new contracts, social media traffic or employee turnover.
How can you improve your asset turnover ratio?
To boost your asset turnover ratio, look for ways to increase your net sales. For example, provide store credit instead of refunds, or consider offering new products or service lines that don’t require new assets. That way, you can generate new revenue streams without making significant investments.
Other techniques might include improving your inventory management, leasing certain assets instead of buying them, accelerating your accounts receivable collection, and improving your overall efficiency, such as through automation or technology.
Note that while it’s possible to game the ratio, such as by selling off assets to prepare for declining growth, this only makes a company’s efficiency look good on paper. It doesn’t change the underlying health of the operations.
How does asset turnover ratio relate to net profit margin and return on investment?
The asset turnover ratio is closely connected to profit margin and return on investment (ROI):
- Net profit margin is the after-tax profit generated by each sales dollar.
- ROI measures the profits generated from investments.
While asset turnover ratio is calculated as net sales (or revenues) divided by assets, ROI is calculated as net profit (i.e., income) divided by assets (costs):
But underlying this formula are other calculations, including the net profit margin (net profit divided by sales) and asset turnover (sales divided by assets):
Thus, the asset turnover ratio is part of the ROI equation.
“The main takeaway here is that you can improve your ROI by taking two kinds of actions: you can improve your profit margin, or you can improve your use of assets,” says Sponem. “That is how these three concepts are linked.”
Learn about forecasting sales and inventory and shortening customer payment terms by downloading the free BDC guide, Taking Control of Your Cash Flow.