Understanding the total asset turnover ratio
Christina Pomoni asked:
The operating performance of a firm is examined with the use of operating efficiency ratios. Efficiency ratios scan how the firm uses its assets and capital measured by dollars of sales generated by various asset and capital components.
Total Asset Turnover ratio indicates the effectiveness of the firm’s use of its total asset base and it is calculated as follows:
Total Asset Turnover = Net Sales / Average Total Net Assets
In order to depict the firm’s operating performance, Total Asset Turnover ratio should always be compared to the industry average because it varies greatly between different industries. In capital-intensive industries (steel, autos and heavy manufacturing companies) Total Asset Turnover ratio is typically less than one, while in retail and services companies it may be over ten.
In addition, Total Asset Turnover ratio reflects a range of turnover values consistent within the industry. For example, a high Total Asset Turnover ratio relative to the industry average might imply that the firm does not generate a sufficient volume of business (sales) given its total asset investment because is tying up capital in excess assets relative to the needs of the firm and its competitors. Also, a high Total Asset Turnover ratio relative to the industry average might be the result of using outdated, obsolete and fully depreciated assets which does not generate high sales volumes.
Example
We need to calculate the Total Asset Turnover ratio of firm X, which is a big retailer.
Our inputs are:
Net Sales = 32,500$ ml
Net Assets (current year) = 11,400$
Net Assets (previous year) = 9,800$
Average Net Assets = (11,400$ + 9,800$) / 2 = 10,650$
Plugging above figures to the formula we derive:
Total Asset Turnover ratio = 32,500 / 10,650 = 3.05 times
If he industry average is lower than 3.05r, then firm X generates a sufficient volume of business (sales) given its total asset investment.
If the industry average is higher than 3.05r, then firm X does not generate a sufficient volume of business (sales) given its total asset investment.
Other implications
Beyond analyzing a firm’s total asset base, it is useful to focus on fixed assets, receivables and inventories in order to evaluate Total Asset Turnover ratio. This is important especially if a firm has experienced a major decline in its total assets turnover as a result of a decline in any of the component turnovers. For example, an exceedingly high fixed assets turnover might indicate a lack of productive capacity to meet sales. Also, a high receivables turnover expresses a great deviation of a firm from the industry norm indicating that the firm collects its receivables in a greatly longer period than what competitors do and this affects its liquidity efficiency by increasing the capital tied up and the possibility of bad debts. Finally, an abnormally high inventory turnover may indicate inadequate inventory that could lead to backorders and slow delivery to customers, having eventually an adverse effect on sales. Therefore, in order to measure how effectively a firm is managing its assets, analyst should consider above component turnovers.
The operating performance of a firm is examined with the use of operating efficiency ratios. Efficiency ratios scan how the firm uses its assets and capital measured by dollars of sales generated by various asset and capital components.
Total Asset Turnover ratio indicates the effectiveness of the firm’s use of its total asset base and it is calculated as follows:
Total Asset Turnover = Net Sales / Average Total Net Assets
In order to depict the firm’s operating performance, Total Asset Turnover ratio should always be compared to the industry average because it varies greatly between different industries. In capital-intensive industries (steel, autos and heavy manufacturing companies) Total Asset Turnover ratio is typically less than one, while in retail and services companies it may be over ten.
In addition, Total Asset Turnover ratio reflects a range of turnover values consistent within the industry. For example, a high Total Asset Turnover ratio relative to the industry average might imply that the firm does not generate a sufficient volume of business (sales) given its total asset investment because is tying up capital in excess assets relative to the needs of the firm and its competitors. Also, a high Total Asset Turnover ratio relative to the industry average might be the result of using outdated, obsolete and fully depreciated assets which does not generate high sales volumes.
Example
We need to calculate the Total Asset Turnover ratio of firm X, which is a big retailer.
Our inputs are:
Net Sales = 32,500$ ml
Net Assets (current year) = 11,400$
Net Assets (previous year) = 9,800$
Average Net Assets = (11,400$ + 9,800$) / 2 = 10,650$
Plugging above figures to the formula we derive:
Total Asset Turnover ratio = 32,500 / 10,650 = 3.05 times
If he industry average is lower than 3.05r, then firm X generates a sufficient volume of business (sales) given its total asset investment.
If the industry average is higher than 3.05r, then firm X does not generate a sufficient volume of business (sales) given its total asset investment.
Other implications
Beyond analyzing a firm’s total asset base, it is useful to focus on fixed assets, receivables and inventories in order to evaluate Total Asset Turnover ratio. This is important especially if a firm has experienced a major decline in its total assets turnover as a result of a decline in any of the component turnovers. For example, an exceedingly high fixed assets turnover might indicate a lack of productive capacity to meet sales. Also, a high receivables turnover expresses a great deviation of a firm from the industry norm indicating that the firm collects its receivables in a greatly longer period than what competitors do and this affects its liquidity efficiency by increasing the capital tied up and the possibility of bad debts. Finally, an abnormally high inventory turnover may indicate inadequate inventory that could lead to backorders and slow delivery to customers, having eventually an adverse effect on sales. Therefore, in order to measure how effectively a firm is managing its assets, analyst should consider above component turnovers.
