Asset turnover is a comparison of sales to assets. The intent is to show the amount of sales generated by investing in a certain amount of assets. Thus, a high turnover ratio should mean that management is making excellent use of a small investment in assets to create a large amount of sales. The basic asset turnover formula is:
Annualized sales ÷ Assets
The asset turnover formula can be subdivided for various types of assets, such as:
- Accounts receivable turnover ratio
- Inventory turnover ratio
- Fixed asset turnover ratio
- Working capital turnover ratio
The asset turnover concept is more commonly applied to all of a company's assets, so that you can see the total impact on sales of all asset investments, particularly in trade receivables, inventory, and fixed assets.
For example, ABC International generated $1,000,000 in sales in the past year. During that year, its average receivables were $350,000, average inventory was $150,000, and average fixed assets were $500,000. The calculation of its asset turnover ratio is:
$1,000,000 Sales ÷ ($350,000 Receivables + $150,000 Inventory + $500,000 Fixed assets)
= 1.0 Asset turnover ratio
A business can alter its asset turnover in a number of ways. For example:
- Depreciation can be recorded on an accelerated basis to more rapidly shrink the recorded amount of fixed assets.
- Receivables can be altered by instituting a tighter or looser credit policy.
- Inventory can be eliminated by outsourcing production.
- Inventory levels can be altered by changing the policy for how fast merchandise orders will be fulfilled.
The asset turnover concept does not always work, since some industries require very small investments in assets to generate sales, while other industries require a massive asset investment before any sales can be produced. For example, a services business such as preparing tax forms for clients requires minimal assets, while an oil refinery calls for a large investment in equipment. Because of these differences, it is best to compare the asset turnover results for a business to those of a company located in the same industry. It is also useful to track the asset turnover ratio on a trend line, to see if there are material changes in the ratio over time.
The asset turnover measurement merely compares sales to assets; it does not provide any indication of the ability of a company to generate a profit. Thus, it is better to cluster an asset turnover measurement with a net profit measurement, to gain a combined view of both profitability and asset usage.