Advantages and Disadvantages of Assets Turnover Ratio

The asset turnover ratio is the measurement of the company’s efficiency in using available assets to generate sales. It is the percentage that gets from the net sale over the total assets.

Assets are the resources that are controlled and owned by the company which are raised from shareholders’ capital or debt financing. The company expects to use the assets to generate more income and expand the business. The income should be higher than the expenses which allow the business to grow and increase shareholders’ wealth.

Assets Turnover Ratio Formula

\[Assets\ Turnover\ Ratio = {Net\ Sale \over Average\ Total\ Assets}\]

Advantages of Assets Turnover Ratio

  • Measure company performance: It is one of the tools that reflect the company’s performance. Investors are looking for investments that can maximize their wealth. A high asset turnover ratio is such a good sign for them.
  • Allow the comparison: It is very common for investors to compare one company to another before making any decision.
  • Focus on the dollar value generated by the asset: The company already owns the assets, so they needs to be in a position that provides benefits to the company. Before buying new assets, management needs to look at the benefits assets provide and it will help to reduce unnecessary spending.
  • Asset impairment indication: it can be used as a tool to provide the indication of asset impairment. The sudden drop in the ratio may show that the company assets lost their ability to generate income.

Disadvantages of Assets Turnover Ratio

  • Can’t compare in various industries: It is very hard to compare this ratio across companies in different industries. Service companies require very little assets, so it has a very high ratio. However, energy company needs to invest a huge amount of assets in order to operate. So their assets turnover ratio will be quite low.
  • Not reflect with profit: Even company has high sales compared to available assets, it does not mean that they are making a profit that benefits shareholders.
  • Discourage management to make the new investments: Management will hesitate in making the new investments as it will increase the total assets and decrease the ratio. They will not invest even if it has long-term benefits to the company. They want to have a consistent ratio that allows them to enjoy the performance bonus.
  • Impact of accounting policy: Even if the two companies have a similar sale and total assets, the ratio may be different due to accounting policy. The average total asset value will be impacted by the depreciation policy, impairment, inventory provision, and so on.

Interpretation of Asset Turnover Ratio

The asset turnover ratio is a key financial metric that provides insights into how efficiently a company is utilizing its assets to generate sales. It is calculated by dividing the company’s net sales by its average total assets. The interpretation of the asset turnover ratio involves understanding its implications in the context of the specific industry and company dynamics.

  1. Efficiency of Asset Utilization:
    • High Ratio: A high asset turnover ratio suggests that the company is effectively using its assets to generate revenue. This could indicate efficient operations, effective inventory management, and optimal utilization of production capacity.
    • Low Ratio: A low ratio may signal inefficiency in utilizing assets to generate sales. This might be due to excess inventory, underutilized production capacity, or poor management of assets.
  2. Industry Comparisons:
    • Comparing the asset turnover ratio of a company to the industry average is crucial. Different industries have varying capital intensity and asset structures. For example, retail typically has a higher asset turnover ratio because it relies on fast inventory turnover, while capital-intensive industries like manufacturing may have lower ratios due to the nature of their assets.
  3. Red Flags and Areas of Improvement:
    • A significant deviation from the industry average may raise concerns. A company with a lower ratio than its peers might need to assess its operational efficiency, streamline its processes, or reevaluate its asset management strategies.
    • On the other hand, a substantially higher ratio may suggest aggressive sales strategies but could also indicate potential risks such as over-reliance on short-term assets.
  4. Benchmarking:
    • Regularly benchmarking the asset turnover ratio against industry peers or historical performance helps assess the company’s consistency and improvement over time.
    • Benchmarking can also highlight areas where the company outperforms or lags behind industry norms, providing insights for strategic decision-making.