Accounting for Entrepreneurs #2 : Calculating Asset Utilization

Accounting for Entrepreneurs #2 : Calculating Asset Utilization

What it Measures

How efficiently an organisation uses its resources and in turn, the effectiveness of the organization’s managers.

Why is it Important

The success of any enterprise is tied to its ability to manage and leverage its assets. Hefty sales and profits can hide any number of inefficiencies. By examining several relationships between sales and assets, asset utilisation delivers a reasonably detailed picture of how well a company is being managed.
Moreover, since all figures used in this analysis are taken from a company’s balance sheet or profit and loss statement, the ratios that result can be used to compare a company’s performance with individual competitors and with industries as a whole.
Many companies also use this measure not only to evaluate their aggregate success but also to determine compensation for managers.

How it works in Practice

Asset utilisation relies on a family of asset utilisation ratios also called activity ratios. The individual ratios in the family can vary, depending on the practitioner. They include measures that also stand alone, such as accounts receivable turnover and asset turnover. The most commonly used sets of asset utilisation ratios include these and the following measures.
Average collection period is also known as days sales outstanding. It links accounts receivable with daily sales and is expressed in a number of days, the lower the number, the better the performance. Formula:
Accounts receivable/average daily sales=average collection period
Inventory turnover compares the cost of goods sold (COGS) with inventory, for this measure, expressed in ‘turns’, the higher the number the better . its formula is:

Cost of goods sold/inventory

Some asset utilisation repertoires include rations like debtor days, while others study the relationship listed below:

Depreciation/Assets measures the percentage of assets being depreciated away to gauge how quickly the product is ageing and assets are being consumed.
Depreciation/Sales measures the percentage of sales that are tied up covering the wear and tear of the physical plant.
In either case, a high percentage could be a cause of concern.

Income/Assets measures how well management uses its assets to generate net income. It is the same formula as return on assets.
Income/Office measures how effectively a company uses its investment in fixed assets to generate net income.
In these two instances, high numbers are desirable.

Office/Assets expresses the percentage of total assets that are tied up in land, building and equipment

By themselves, of course, the individual numbers are meaningless. Their values lie in how they compare with the corresponding numbers of competitors and industry averages. A company with an inventory turnover of 4 in an industry where the average is 7, surely has room for improvement because the comparisons indicate it is generating fewer sales per unit inventory and is, therefore, less efficient than its rivals.

Tricks of the trade:

  1. Asset utilisation is particularly useful to companies considering expansion or capital investment, if production can be increased by improving the efficiency of existing resources there is no need ti spend the sums expansion would cost.
  2. Like all families of ratios, no single number or comparison is necessarily causing for alarm or rejoicing. Asset utilisation proves most beneficial over an extended period of time.

 

Reference: The Ultimate Business Resource