Business, Legal & Accounting Glossary
Asset turnover ratio is a financial ratio that measures a firm’s efficiency at using its assets in generating sales or revenue. These ratios help to measure the productivity of a company’s assets. A high asset turnover ratio is desirable as compared to a low ratio since the former is indicative of better operating performance. A higher asset turnover ratio symbolizes greater shareholder wealth. It also indicates pricing strategy: companies with low-profit margins tend to have high asset turnover, while those with high-profit margins have low asset turnover.
The asset turnover ratio calculates the total revenue that is generated for every dollar of asset owned by the company. To calculate asset turnover, take the total revenue or the net sales of the company and divide it by the total assets for the period.
Asset Turnover = Net Sales/ Total Assets
For example, if XYZ Ltd has $40 million of assets and $100 million of sales then its asset turnover is 250% or 2.5x. If the company’s sales increase to $200 million with the same assets, its asset turnover is 500% or 5.0x. and its efficiency in the use of its assets has increased by 100%.
Three commonly used asset turnover ratios are Receivables, Inventory, and Fixed Asset.
The receivables turnover ratio is a good indicator of the average time needed to convert receivables into cash. It calculates the average time taken by the firm to collect its accounts receivables and is defined as follows:
Receivables turnover ratio = Annual credit sales/ Accounts Receivable
Another common measure used to report receivables turnover is the collection period. It refers to the number of days that credit sales remain in accounts receivable before they are collected. This value should be close to the credit terms that the company gives its customers. It is calculated by dividing the accounts receivable balance by the average daily credit sales.
Average Collection period = Accounts Receivable/ ( Annual Credit Sales/ 365)
Taking the above example, if XYZ Ltd has $10 million of receivables and $100 million of sales then its receivables turnover ratio can be calculated by dividing the sales (100) by receivables (10) giving 10 times as the receivables turnover ratio and the collection period as 36.5 days which compares favorably with company’s standard credit term of 31 days.
The inventory-turnover ratio gives a general view of the inventories of a company. This ratio measures the number of times, on average, the inventory is sold within a given financial reporting period. Its purpose is to measure the liquidity of the inventory. It indicates the rapidity with which the company is able to move its merchandise.
This ratio should be compared against industry averages as it may vary widely with the industry. Retail stores and grocery chains are going to have a much higher inventory turn rate since they are selling products that generally range between $1 and $50 as against the Companies that manufacture heavy machinery such as airplanes, which are going to have a much lower turnover rate since each of their products may sell for millions of dollars. Similarly, hardware companies may only turn their inventory 3 or 4 times a year, while a department store may do twice that, turning at 6 or 7. Because inventories are the least liquid form of asset, a high inventory turnover ratio is generally positive. On the other hand, an unusually high ratio compared to the average for the industry could mean a business is losing sales because of inadequate stock on hand. At the same time, a low turnover implies poor sales and inefficiency, and therefore, excess inventory.
The inventory turnover ratio is calculated by dividing the annual sales of the company by its inventory.
Inventory Turnover = Sales/ Inventory
The result represents the turnover of inventory or how many times inventory was used and then again replaced. This number is usually representative of a one-year time period.
A popular variant of the Inventory turnover ratio is to convert it into an average days it takes to sell the inventory on hand or “inventory turnover days”. It is calculated by dividing the days in the period by the inventory turnover times.
Average days to sell the inventory = 365/ Inventory Turnover Ratio
The inventory turnover ratio is figured as “turnover times” while the average days to sell the inventory is in “days”.
Taking the above example, if XYZ Ltd has $10 million of inventory for the same, $100 million of sales then its inventory turnover ratio can be calculated by dividing the sales (100) by inventory (10) giving 10 times as the inventory turnover ratio. The same can be converted to inventory turnover days by dividing 365 by the turnover time (10) giving 36.5 days as the average time it takes for the company to sell its inventory.
Total assets include current assets, fixed assets, and intangible assets such as licenses and goodwill. Fixed assets entail huge initial investments that are undertaken with the hope of maximizing revenue. Hence, the fixed-asset turnover ratio is a better indicator of operating performance as compared to the total asset turnover ratio.
It measures the revenue that is generated by the company/management per dollar of fixed assets.
The formula for fixed asset turnover ratio is as follows:
Fixed Asset Turnover Ratio = Revenue / Average Fixed Assets
Taking the above example, if XYZ Ltd has $20 million of fixed assets and $100 million of sales then its fixed turnover ratio is 5x implying that the company earns five-dollar revenue for every dollar of fixed asset investment.
The fixed asset turnover ratio is more relevant for capital-intensive industries since the size of the fixed asset base depends on whether the process of production is labor-intensive or capital intensive. In general, companies that are labor-intensive have a higher fixed asset turnover ratio as compared to companies that are capital intensive. Hence, it is better to compare firms within the same industry rather than comparing them across industries to get a true picture of a firm’s relative operating performance. Also, a firm’s past performance can be compared with the current performance for a better understanding of the company’s prospects.
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This glossary post was last updated: 22nd November, 2021 | 0 Views.