What is Your Business’s Asset Turnover Ratio?
In the simplest terms, your asset turnover ratio shows you how efficiently your company is using its assets to generate sales. It’s also an important ratio to know because your asset turnover ratio will likely be important to potential investors.
Fortunately, calculating this ratio and using it is straightforward once you understand a few principles. To that end, this article will review the definition of the asset turnover ratio, its formula, and how you can improve your ratio.
The Formula and Definition of Asset Turnover Ratio
The Corporate Finance Institute defines the asset turnover ratio formula as, “equal to net sales divided by the total or average assets of a company.”
Expressed as a formula, the ratio looks like this:
Of course, to use this formula you’ll need to know what your net sales and total assets are. To calculate net sales, you take your gross sales number and subtract all returns, discounts, and allowances. To get your total assets number, you can look on your company’s balance sheet.
Examples of Asset Turnover Ratios in Action
To fully understand this ratio and how to use it, it’ll help to think through a couple of examples.
So, for example, let’s say you wanted to use your asset turnover ratio to compare your company’s historical efficiency against its efficiency in 2020.
In this case, you’d use the above formula to come up with two ratios. The first ratio would divide net sales from 2014 to 2019 by total assets for the same period. The second ratio would divide net sales by total assets for the year 2020.
This is an important example because it shows how the period you use for net sales and total assets depends on what you’re trying to measure.
It’s also important to understand this ratio from the perspective of an investor. Since they’re evaluating your company as an investment opportunity, they’re interested in how efficient your business is relative to others. So what they’ll often do is take your asset turnover ratio for a given period and compare it to other, similar companies.
However, it’s critical to use the asset turnover ratio only for comparing similar companies. For example, it wouldn’t make sense to use this ratio for comparing a contracting business against a small chain of restaurants.
How You Can Improve Your Business’s Asset Turnover Ratio
Since your business’s asset turnover ratio is a measure of efficiency, it’s almost always a good idea to try to improve it. Put simply, the two ways you can improve your ratio are:
- Increase your net sales at a faster rate than your total assets.
- Decrease your total assets at a faster rate than your net sales.
There’s countless ways you can accomplish both of these tasks, but here are a few common strategies used to improve a business’s asset turnover ratio:
1. Invest in new equipment or technology
Thought it might seem counterintuitive, allocating more capital to your assets can improve efficiency. That said, it’s not a one-size-fits-all solution. Oftentimes it’s not the assets themselves that need to be upgraded. It’s how those assets are deployed that may need to be rethought.
2. Audit and update your strategic plan
It’s easy to get swept up into the day-to-day hurry, as any small business owner knows. However, as your company evolves, it’s important to take time to periodically revisit or update your business’s strategic approach. If you haven’t done this in a while, you may find all sorts of inefficiencies that need to be rooted out.
3. Invest in your sales force
Though difficult to execute, you can improve efficiency by developing existing salespeople, hiring new ones, or equipping your sales team with new tools. While each of these initiatives come with a cost, if your sales outpace your spending, you can grow your business efficiently.
The Limitations of the Business Asset Turnover Ratio
The asset turnover ratio is a very useful measure. However, before you start thinking about how to improve this ratio, it’s important to keep in mind that an improved ratio doesn’t always mean a healthier business.
In theory and reality, your asset turnover ratio could improve while your sales volume is decreasing, so long as the value of your assets is decreasing faster. Unless you’re winding down a part of your business, decreasing asset values and sales volume is not a good sign.
Also, if you’re using this ratio to compare efficiency between companies, make sure you’re only using it to compare similar firms. An above-average asset turnover ratio in one industry may be well below average in another.
All that said, so long as you keep its limitations in mind, the asset turnover ratio is one of many useful measures you should use to assess your business’s health.
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