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Owners are ever alert to how well their companies are operating. Dozens of ratios are used to measure a company's efficiency, profitability and growth. The asset turnover ratio (ATR) is a measure of how well a company is using its assets to generate sales.
Asset Turnover Ratio Defined
Asset turnover ratio is a measure of a company's ability to use its assets to generate sales. ATR is defined as follows:
Asset Turnover Ratio = Net Sales / Average Assets
Assets are things of value owned by the business. They are classified as current assets, which include cash, accounts receivable, inventory and prepaid expenses, and noncurrent assets, which include property, plant, equipment, goodwill and patents. Assets are used up or converted into other assets in order to generate revenue for the company. For example, a machine deteriorates over time and loses value. Cash is spent, accounts receivable are collected, inventory is sold and so forth. In the ATR formula, the denominator refers to the total assets of the company. Average assets are the company's total assets averaged over a reporting period—a month, quarter or year.
Sales are the revenues collected from the sale of goods and services. Top line sales, or gross sales, are the sales booked by the company. Net sales are gross sales with certain adjustments made after the sale that reduce the revenues collected, as described in the section below.
The ATR varies widely from one industry to another, but it can shed light on the relative efficiency among competitors within the same industry. The ATR increases when assets are used efficiently, but businesses must take care to avoid temporary distortions in the ratio—such as sales slumps.
How to Calculate Asset Turnover Ratio
The components of the ATR calculation can be taken directly from a company's financial reports—assets from the balance sheet and sales from the income statement. The numerator, net sales, is calculated as:
Net Sales = Gross Sales – Returns – Allowances – Discounts
Average assets are calculated as:
Average Assets = (Ending Total Assets Previous Period + Ending Total Assets Current Period) / 2
The sales period, either a month, quarter or year, must match the period between the two balance sheets.
The following table defines the components of the ATR.
|Gross Sales||The value of goods or services sold over the course of a reporting period.||Income Statement|
|Returns||The cost of returned items.||Income Statement|
|Allowances||Reduction in sales revenues due to damage and missing goods.||Income Statement|
|Discounts||Price concessions after the sale.||Income Statement|
|Starting Assets||Total assets at end of previous reporting period.||Balance Sheet|
|Ending Assets||Total assets at end of current reporting period.||Balance Sheet|
The following information was gleaned from the financial statements of Jimmy's Costume Shop:
- Balance sheet assets, Dec. 31, 2016: $123,000
- Balance sheet assets, Dec. 31, 2017: $148,000
- Gross sales for 2017: $297,000
- Returns for 2017: $3,000
- Allowances for 2017: $1,000
- Discounts for 2017: $0
- ATR = Net Sales / Average Assets
- ATR = (Gross Sales – Returns – Allowance – Discounts) / ((Starting Assets + Ending Assets) / 2)
- ATR = ($297,000 – $3,000 – $1,000 – $0) / (($123,000 + $148,000) / 2)
- ATR = $293,000 / $135,500
- ATR = 2.16
The ATR for Jimmy's Costume Shop, a retail store, is 2.16.
How to Interpret Asset Turnover Ratio
ATRs vary among different industries and sectors. Some sectors, like retail, don't need many fixed assets, which tends to support relatively high ATRs. Conversely, utilities usually require many fixed assets in order to generate revenues. The following table shows average ATRs by sector.
Interpreting Asset Turnover Ratio
Business owners should interpret ATR as an indication of how well they are putting their assets to work. If their ATR is below the industry average, it's a warning that some assets are not being used to their full extent, or the assets are redundant or inefficient. This can help a company strategize about liquidating inefficient assets and/or replacing them with new ones. As we can see from the ATR by Sector table, the average ratio for retailers is 2.15. Jimmy's Costume Shop's ATR of 2.16 is above average, which means the business’s assets are being utilized efficiently.
The ATR should be viewed over several years to track trends. In any given year, ATR might radically change due to large purchases or sales of assets. In addition, a downturn in the economy can hurt sales and reduce the ATR. Reviewing ATRs in a historical context is the best way to understand the ratio's significance.
How to Improve Your Business's Asset Turnover Ratio
An anemic ATR can stem from problems with sales, invoice collection, inventory management or production. You can adopt one or more strategies to improve your ATR, including the following.
- Boost sales: Lackluster sales reduces the numerator of the ATR, so improving sales will increase your ATR. You might consider increasing the average sales per customer, finding new customer segments or increasing your line of offerings (without additional assets).
- Reduce inventory: Too much inventory might mean inefficient management. Although inventory is a current asset, it can sit on the books for many months. Explore strategies to more closely match inventory supply with demand.
- Get rid of unwanted assets: If you have old or unused assets, get rid of them. If you can get cash for them, you can use the extra money to improve your business. You might have underutilized equipment or space you can rent out to others. Reduce cash locked up in bank accounts and use it for investment and growth.
- Lease: Think about leasing rather than buying long-term assets. Leased assets don't figure into ATR, and you can replace and upgrade assets after the lease ends without carrying depreciated assets on your balance sheet.
- Collections: If you use cash accounting, consider improving your collection processes and reducing the collection period of receivables. Accrual-based companies won't benefit from this strategy since the revenues are recognized when earned rather than when collected.
- Upsell: Try improving your offering mix to increase your sales margins. This will boost your net sales and raise your ATR.
- Upsize your assets: You might achieve economies of scale by using larger warehouses and stores. This can reduce your unit costs, increase your profits and lift your ATR.
A higher ATR will also sit well with lenders who want indications that borrowers have sufficient revenues to pay back loans. All things being equal, a better ATR will tend to make a borrower seem more creditworthy and result in easier access to loans with better terms.