The asset turnover ratio measures how effectively a company uses its assets to generate revenue or sales. The ratio compares the dollar amount of sales or revenues to the company's total assets to measure the efficiency of the company's operations.

A higher ratio is generally favored as there is the implication that the company is more efficient in generating sales or revenues. A lower ratio illustrates that a company may not be using its assets as efficiently. Asset turnover ratios vary throughout different sectors, so only the ratios of companies that are in the same sector should be compared. The ratio is typically calculated on an annual basis, though any time period can be selected.

Calculating the Asset Turnover Ratio

The asset turnover ratio compares performance from the income statement with the company's financial health on the balance sheet. The formula is:

Asset Turnover Ratio = Net Sales / Average Total Assets

Net sales is the total amount of revenue retained by a company. It is the gross sales from a specific period less returns, allowances, or discounts taken by customers. When comparing the asset turnover ratio between companies, ensure the net sales calculations are being pulled from the same period.

Average total assets are found by taking the average of the beginning and ending assets of the period being analyzed. The standard asset turnover ratio considers all asset classes including current assets, long-term assets, and other assets.

The asset turnover ratio is expressed as a rational number that may be a whole number or may include a decimal. By dividing the number of days in the year by the asset turnover ratio, an investor can determine how many days it takes for the company to convert all of its assets into revenue.

Asset Turnover Ratio Example

Suppose company ABC had total revenue of $10 billion at the end of its fiscal year. Its total assets were $3 billion at the beginning of the fiscal year and $5 billion at the end. Assuming the company had no returns for the year, its net sales for the year was $10 billion. The company's average total assets for the year was $4 billion (($3 billion + $5 billion) / 2 ).

ABC Company's Asset Turnover Ratio = $10 billion / $4 billion = 2.5

On the other hand, company XYZ - a competitor of ABC in the same sector - had total revenue of $8 billion at the end of the same fiscal year. Its total assets were $1 billion at the beginning of the year and $2 billion at the end.

XYZ Company's Asset Turnover Ratio = $8 billion / $1.5 billion = 5.33

Though ABC has generated more revenue for the year, XYZ is more efficient in using its assets to generate income as its asset turnover ratio is higher. XYZ has generated almost the same amount of income with over half the resources as ABC.

Interpreting the Asset Turnover Ratio

The asset turnover ratio is most useful when compared across similar companies. Due to the varying nature of different industries, it is most valuable when compared across companies within the same sector. The asset turnover ratio can also be analyzed by tracking the ratio for a single company over time. As the company grows, the asset turnover ratio measures how efficiently the company is expanding over time - especially compared to the rest of the market. Although a company's total revenue may be increasing, the asset turnover ratio can identify whether that company is becoming more or less efficient at using its assets effectively to generate profits. Companies can artificially inflate their asset turnover ratio by selling off assets. This improves the company's asset turnover ratio in the short term as revenue (the numerator) increases as the company's assets (the denominator) decrease. However, the company then has fewer resources to generate sales in the future. The asset turnover ratio calculation can be modified to omit these uncommon revenue occurrences.

A key component of DuPont analysis is the asset turnover ratio. A system that began being used during the 1920s to evaluate divisional performance across a corporation, DuPont analysis calculates a company's return on equity (ROE). It breaks down ROE into three components, one of which is asset turnover.

The Bottom Line

The asset turnover ratio helps investors understand how effectively companies are using their assets to generate sales. Investors use this ratio to compare similar companies in the same sector or group to determine who's getting the most out of their assets. The asset turnover ratio is calculated by dividing net sales or revenue by the average total assets.