There are various ratios used by financial adepts to determine how well the company is doing in a particular field compared to some fundamental factor. The asset turnover ratio, for instance, estimates how effectively the company uses its assets.
While calculating this ratio, you’d compare the company’s profits from sale revenues to the value of their assets. Basically, it would tell you whether it turns these assets into more value or not. If it does, then it probably generates profit. If not, then it is not doing too good.
This ratio can be used for various purposes, including risks assessment for investments. That being said, it’s a great indicator of the general financial health of a company.
In order to calculate this ratio, you’ll have to take several pieces of information, including:
- Sales per period (S)
- Assets value at the beginning of that period (V1)
- Assets value at the end of that period (V2)
The reported period can be really anything – from the month to the year to the entire existence of the company. The annual ratio would give you the most useful data, especially considering that you’ll likely have to compare this data to similar information received from other periods.
So, the formula is, as follows:
Turnover Ratio = S/((V1+V2)/2)
Basically, you’ll need to calculate the average value of assets for the period that you decided to calculate. It means you’ll have to take the lowest number (in the beginning) and the biggest number (in the end) and divide it by 2. Then, you’ll have to take the total sales in that period and divide them by this average value of assets.
Understanding the ratio
What you receive as a result of all these calculations is a number that reflects the ratio. Depending on what it is, it can mean several things for you and the company you analyzed. For instance:
If the ratio is 1, then the company’s sales equal the asset value it possessed in that same timeframe. It means it sells the same amount of value as its products’ worth.
It’s not immediately a bad or a good thing. The ratio isn’t company sales to company losses. What it means is that its assets produce value that matches their own. It’s a neutral result, and you could say the company works at 100% efficiency. That being said, it is better when the output is even greater compared to the assets’ worth.
If the ratio is >1, then the company assets produce more worth than they have themselves. It’s usually a good thing, although it doesn’t usually mean that the company is doing well, as you’ll see further.
If the ratio is <1, then company doesn’t utilize its assets to their full value. Although it doesn’t seem good, it may actually be a good result for the company’s line of work.
The challenge of making sense of these ratios is that there isn’t a universal number by which we can estimate the efficiency of a company’s work. Again, it doesn’t show if the company is just making a profit. It depends on the specific industry and their average numbers.
Some industries (such as real estate) naturally have more value in their assets. However, they can’t sell this value fast enough, which means few sales in relation to the massive value they possess. In addition, it won’t mean they aren’t profitable because real estate has few real expenditure accounts.
Other industries (such as retail stores) are capable of producing a lot of wealth out of virtually nothing. Companies like Walmart generate giant profits even though products they have in stock aren’t very costly to produce. The markup, as well as a sheer volume of sales, does the trick.
On its own, Walmart’s ratio of 2.21 (in 2021) won’t tell you much. However, the whole idea is to compare these numbers to the companies in the same industry. For instance, Target has an asset turnover ratio of 1.8 (in 2020), while Best Buy has 2.38 (in 2021).
What it tells you is that Walmart is in the middle ground in terms of asset usage efficiency amongst top retailers in America. Do with this information what you like. You can actually draw several interesting conclusions.
Using the ratio to your advantage
The companies would use their ratios to determine whether their sales or asset property decreased since the previous year. They would usually want to keep it at the same level through the fiscal years. Ideally, it means an increased amount of sales alongside a proportionally increased value of assets.
It still means they get more profit compared to the previous year while having more actual value, which is great news.
The investors, by comparison, would use this information to determine which company in the industry is more beneficial to invest in. You don’t just need to determine the best ratio in the market, but also see which of them changed better throughout the years. Best Buy’s 2.38 may not be so great, considering it was 2.73 the year before.
It may be a universal thing, but it may very well be just their problem. Researching into these things will give you all the answers. Generally, the asset turnover ratio isn’t the only number you should be looking into, but it’s a good enough place to start.