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 an entity uses a minimal amount of working capital and fixed assets in its daily operations.
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
For example, 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.
A failing of this ratio is that 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. The ratio can also 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)
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.
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.