The Asset Turnover Ratio is a method of evaluating a company’s ability to efficiently use its assets. It is defined as the sales or revenues for a given period of time divided by the average value of total assets over that same period of time. A high number means more of a company’s assets are used to produce revenue, and therefore efficiently make money.
To find an asset ratio for a particular period of sales revenue, you will need to find the average value of a company’s total assets – equipment, buildings, inventory, accounts receivable, and cash – done by adding the values at the beginning and end of the period of dividing by two. (This information can be found in the quarterly 10-Q or annual 10-K filings filed by public companies)
Asset turnover ratios are generally specific to sectors or industries. For example, a retail clothing chain is going to have a different asset turnover ratio than a capital-intensive manufacturing operation, because a much larger percentage of the retailer’s assets are in salable inventory. As a result, asset turnover ratios can only be reasonably compared for companies that are in the same field.
Indeed, in the asset turnover ratio rankings by sector at CSIMarket.com, the Retail sector ranks first with an overall ratio of 2.03 – meaning that for every dollar in assets, $2.03 in revenue is generated. The next closest sectors are Consumer Non-Cyclical and Energy, tied at 0.94.
What does asset turnover mean to investors? As with most fundamentals, you are looking for trends and relative comparisons to competitors and other companies in the sector.
By multiplying the asset turnover ratio by the profit margin (Net Income divided by Sales), you can derive the return on assets, which relates the asset turnover ratio to the profit generated and not just the income. Typically, high asset turnover industries and companies have lower profit margins (such as retail sales), and vice versa. If a company has an asset turnover ratio that is unusual for its sector, check to see how it is affecting profits.
If revenue is relatively constant but the asset turnover ratio is decreasing, for some reason assets are not being turned into revenue as efficiently as before. Perhaps investments have been made to increase capacity and there is a lag time until that begins to generate revenue, which is perfectly acceptable. On the other hand, it could be a negative indicator of excessive inventory or unused capacity.
It is not necessarily good news if the asset turnover ratio is increasing with flat revenue. It could be that a company is becoming more efficient, or it could mean that a company is at the limit of its capacity and needs some strategic investment to expand and grow.
This illustrates one of the simultaneous strengths and weaknesses of asset turnover ratio as a barometer of a company’s financial health – it gives a general, comprehensive picture of the efficiency of a company at making money, but it doesn’t really tell you where any problems are located. It doesn’t give any indication of problems with any specific assets, thus you have to dig further to find the reason for the inefficiency and whether that inefficiency is temporary or systemic.
Effectively, asset ratio is a simple indicator, roughly analogous to the Check Engine Light on your dashboard. By itself, it doesn’t have much meaning, but it does suggest that you dig deeper into the reason for any changes or relatively poor numbers. The underlying reason for the changes could be either positive or negative, and it is up to you as an investor to find the underlying reasons and change your investment strategy accordingly.