Asset Turnover Ratio

Asset turnover ratio is the ratio between the net sales of a company and total average assets a company holds over some time; this helps in deciding whether the company is creating enough revenues to make sure it is worth it to hold a heavy amount of assets under the company’s balance sheet.

In simple terms, the asset turnover ratio means how much revenue you earn based on the total assets. And this revenue figure would equate to the sales figure in your Income Statement. The higher the number the better would be the asset efficiency of the organization. It’s being seen that in the retail industry, this ratio is usually higher, i.e., more than 2.

On 31^st January 2020, Wal-Mart had US $523.96 billion total revenues. And its total assets were US $219.30 billion at the beginning of the year and US $236.50 at the end of the year. So to calculate the average total assets, we need to take the average of the figure at the beginning of the year and of the figure at the end of the year, i.e. (US$ 236.60 billion + US$219.30 billion)/2 = US$228.1 billion. Then the asset turnover of Wal-Mart would be precisely (US $523.96 billion / US$228.1 billion) = 2.29x

So, if you have a look at the figure above, you will visually understand how efficient Wal-Mart asset utilization is. The revenue is more than double of what assets they have.

• The asset turnover ratio calculates a company's net sales by its total average assets. This ratio helps determine if the company is generating sufficient revenue to justify holding many assets on its balance sheet.
• A ratio of less than 1 indicates that the company's total assets are not generating enough revenue at the end of the year, which may be unfavorable for the company.
• A ratio greater than one is generally considered favorable, indicating that the company generates sufficient revenue from its assets. 

To calculate the asset turnover ratio, you need to find out the total revenue (the total sales, or you can take the average of the sales figure at the beginning of the year and the end of the year) and then divide it with total assets (or else you can take the average figure at the beginning of the year and the end of the year).

Asset Turnover Ratio Formula = Sales / Average Assets   

There are a few things you should know before we can go to the interpretation of the ratio.

First, what do we mean by Sales or Net sales, and what figure would we take to calculate the ratio? What are total assets, and would we include every asset the firm has, or would there be some exception?

When you calculate a ratio using “Sales,” it usually means “Net Sales” and not "Gross Sales." This “Net Sales” comes in the Income statement, and it is called “operating revenues” for the company for selling its products or rendering any services. If you have been given a figure of "Gross Sales" and you need to find out "Net Sales," look for any "Sales Discount" or "Sales Returns." If you deduct the "Sales Discounts / Returns" from the "Gross Sales," you would get the figure of "Net Sales."

Now let’s come to the total assets. What would we include in total assets? We will include everything that yields a value for the owner for more than one year. That means we will include all fixed assets. At the same time, we will also include assets that can easily convert into cash. That means we would be able to take current assets under total assets. And we will also include intangible assets that have value, but they are non-physical, like goodwill. We will not take fictitious assets (e.g., promotional expenses of a business, discount allowed on the issue of shares, a loss incurred on the issue of debentures, etc.) into account.

It is a  very important thing to consider, as this will ultimately turn out to be your decision about your company in the long run. Let’s interpret two options and discuss these scenarios in detail.

If the asset turnover ratio < 1

• If the ratio is less than 1, then it's not good for the company as the total assets cannot produce enough revenue at the end of the year.
• But this is subject to an assumption. If the asset turnover of the industry in which the company belongs is less than 0.5 in most cases and this company's ratio is 0.9. This company is doing well, irrespective of its lower asset turnover.

If asset turnover ratio > 1

• If the ratio is greater than 1, it's always good. Because that means the company can generate enough revenue for itself.
• But this is subject to an exception. For example, let’s say the company belongs to a retail industry where its total assets are kept low. As a result, most companies' average ratio is always over 2.
• In that case, if this company has an asset turnover of 1.5, then this company isn’t doing well. And the owner has to think about restructuring the company so that the company could generate better revenues.

Here is one thing every company should keep in mind. If you want to compare the asset turnover with another company, it should be done with the companies in the same industry.

Let’s understand this with an example.

Let’s do the calculation to determine the asset turnover ratio for both companies.

First, as we have been given Gross Sales, we need to calculate the Net Sales for both companies.

And as we have the assets at the beginning of the year and the end of the year, we need to find out the average assets for both companies.

Now, let’s calculate the asset turnover ratio for both companies.

Both companies, A and B, are from the same industry. In that case, we can do a comparative analysis. It’s seen that the ratio of Company A is more than the ratio of Company B. As it is assumed that they both belong to the same industry, we can conclude that Company A can utilize its assets better to generate revenue than Company B.

But, let’s say Company A and Company B are from different industries. Then we won’t compare their asset turnover ratio against each other. Rather, in that case, we need to find out the average asset turnover ratio of the respective industries, and then we can compare the ratio of each company.

We have discussed how you would be able to calculate the asset turnover ratio and would also be able to compare among multiple ratios in the same industry.

Let us now calculate Nestle’s Asset Turnover and what we can interpret from the values obtained.

The first step involves extracting the relevant data for Asset Turnover. For Asset Turnover, you require two sets of Data – 1) Sales 2) Assets.

You can access Nestle's Annual reports from here.

Once you have the data for the last 5-6 years, you can put those in excel, as shown below. Calculate the Average Asset size for each year.

The next step is to calculate Asset Turnover = Sales / Average Assets.

Below is Nestle’s Asset Turnover for the past 15+ years.

source: ycharts

So from the calculation, it is seen that the asset turnover ratio of Nestle is less than 1. But that doesn't mean it's a lower ratio. We need to see other companies from the same industry to compare.

Also, you may note from this chart; that Asset Turnovers have shown a decreasing trend over the past 15 years.

Let’s take another example of Asset Turnovers.

Let’s look at the two companies, Colgate and P&G.

source: ycharts

•  For the past ten years, Colgate has been maintaining a healthy Asset Turnover of more than 1.0x
• On the other hand, P&G faces challenges in maintaining an Asset Turnover. Currently, its asset turnover is 0.509x.
• Colgate's Asset Turnover is 1.262 / 0.509 = 2.47x better than P&G.
• We would say that P&G has to improve its asset utilization to increase revenue generation through assets.

As everything has its good and bad sides, the asset turnover ratio has two things that make this ratio limited in scope. Of course, it helps us understand the asset utility in the organization, but this ratio has two shortcomings that we should mention.

• It includes all idle assets: As in the calculation, we take the total assets at the end of the year; we also consider idle assets that shouldn’t have been included.
• It gives a general efficiency ratio: From this ratio, it’s impossible to extract the individual asset utilization data, which limits our understanding of the efficiency of an individual asset.

• Accounting for Sales Discounts
• What are Tangible Assets?
• Definition of Current Assets
• DSCR Ratio
• Current Ratio Meaning

You certainly should use the asset turnover ratio for understanding the efficiency of your assets in the organization, but don't forget to have other ratios handy, like cash ratio, current ratio, quick ratio, fixed asset turnover ratio, equity turnover ratio to understand the overall picture of the company.