Accounting for Entrepreneurs #1 : Calculating Asset Turnover

Accounting for Entrepreneurs #1 : Calculating Asset Turnover

What it Measures

The amount of sales generated for every unit currency worth of assets over a given period.

Why is it Important

Asset turnover measures how well a company is leveraging its assets to produce revenue. A well-managed manufacturer, for example, will make its plant and equipment work hard for the business by minimising the idle time for machines.
The higher the number the better within reason. As a rule of thumb, companies with low profit margins tend to have high profit margins, those with high profit margins have low asset turnover.
This ration can also show how capital intensive a business is. Some businesses, software developers, for example, can generate a tremendous amount of sales per dollar of asset because their assets are modest. At the other end, manufacturing needs huge asset base to generate sales.
Finally, asset turnover serves as a tool to keep managers mindful of the company’s balance sheet along with its profit and loss account.

How it works in Practice

Asset turnover’s basic formula is simply sales divided by assets.

Sales revenue/ Total assets

Most experts recommend using average total assets in the formula. To determine this figure, add total assets at the beginning of the year to total assets at the end of the year divided by two.
If for instance, annual sales totalled 1 crore, and total assets were 20 lakhs at the beginning of the year and 15 lakhs at the year end, the average total assets would be 17.5 lakhs, and asset turnover rate would be:

1 crore / 17.5 lakhs

Tricks of the Trade:

  1. The ratio is especially useful for growth companies to gauge whether or not they are growing revenue or turnover in healthy proportions or assets.
  2. Asset turnover numbers are useful for comparing competitors within industries. Like most nations, they vary from industry to industry. As with most numbers, the most meaningful comparisons are made over extended period of times.
  3. Too high a ratio may suggest overtrading, too many sales revenue with too little investment. Conversely, too low a ratio may suggest under trading and an inefficient management of resources.
  4. A declining ratio may be indicative of a company that overinvested in the plant, equipment or other fixed assets or is not using existing assets effectively.

 

Reference: The Ultimate Business Resource