Asset turnover ratio definition

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What is the Asset Turnover Ratio?

The asset turnover ratio compares the sales of a business to the book value of its assets. The measure is used to estimate the efficiency with which management uses assets to produce sales. A high turnover level indicates that a business uses a minimal amount of working capital and fixed assets in its daily operations. Conversely, a low turnover level may present an opportunity for operational improvements within a business. When using this ratio to evaluate a business, it is best to use other entities within the same industry as a benchmark. The reason is that the other firms likely have similar asset requirements and capital structures.

To calculate the asset turnover ratio, divide sales by total average assets. The average assets figure is derived by adding together the beginning and ending asset totals for the measurement period and dividing by two. The formula is:

Revenue ÷ Total average assets = Asset turnover ratio

Example of the Asset Turnover Ratio

An entity has sales of $1,000,000, beginning total assets of $200,000 and ending total assets of $300,000. Its asset turnover ratio is:

$1,000,000 Revenue ÷ (($200,000 Beginning assets + $300,000 Ending assets) ÷ 2)

= 4:1 Asset turnover ratio 

In the example, the business is generating $4 of sales for every $1 of assets.

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Advantages of the Asset Turnover Ratio

There are some key advantages to using the asset turnover ratio, which are as follows:

  • Measures efficiency. The ratio helps evaluate how effectively a company utilizes its assets to generate sales, making it a useful performance metric.

  • Useful for trend analysis. Tracking the ratio over time helps businesses identify efficiency improvements or declines, which guides strategic decisions.

  • Helps with capital allocation decisions. Companies can use the ratio to determine whether they need to invest in new assets or optimize existing ones to improve performance.

  • Simple to calculate. The ratio requires only net sales and total assets, making it a straightforward financial ratio for quick analysis.

While useful, the asset turnover ratio should be used alongside profitability metrics (e.g., ROA, ROE) and liquidity ratios for a complete financial assessment of a business.

Problems with the Asset Turnover Ratio

There are several problems with the asset turnover ratio. They are as follows:

  • Skewed by industry requirements. Some industries require large investments in assets, such as oil refineries, so that the poor results of the ratio are not truly indicative of the performance of a firm.

  • Skewed by goodwill asset. The ratio can yield incorrect results when a business has built up a large amount of the goodwill asset as a result of acquisition activities, since goodwill is not a productive asset. If this is the case, an alternative formulation for the ratio is:

Revenue ÷ (Total average assets - Goodwill) = Modified asset turnover ratio

  • Can negatively impact a business. Managers can concentrate on improving this ratio too much, resulting in inadequate levels of working capital. For example, a company may insist on extremely short payment terms in order to drive down its accounts receivable investment, which may cause it to lose sales from customers who expect longer terms.