Which of the following ratios measures how efficiently the firm is using its assets to generate sales?

How to calculate the asset turnover ratio

Most companies calculate the asset turnover ratio on an annual basis, using balance sheets from the beginning and end of the fiscal year. The ratio can be calculated by dividing gross revenue by the average of total assets. It should look like this:

asset turnover ratio = gross revenue / average total assets

The average total assets can be found by adding the beginning assets to the ending assets and dividing this sum by two. It should look like this:

average total assets = (beginning assets + ending assets) / 2

In this equation, the beginning assets are the total assets documented at the start of the fiscal year, and the ending assets are the total assets documented at the end of the fiscal year.

How to interpret the asset turnover ratio

As mentioned before, a high asset turnover ratio means a company is performing efficiently, as the ratio means they are generating more revenue per dollar of assets. A low asset turnover ratio indicates the opposite -- that a company is not using its resources productively and may be experiencing internal struggles.

Investors and creditors often look for companies with higher asset turnover ratios because it shows that the business can operate with fewer assets than its less efficient competitors, therefore demanding less debt and equity to operate. This should result in a reduced amount of risk and an increased return on investment (ROI) for all stakeholders.

When analyzing the asset turnover ratio, it is best to find trends over time in a company. This can be done by plotting the data points on a trend line, allowing any patterns or gradual increases and decreases to be observed. However, in order to gain the best understanding of how a company is using its resources, its asset turnover ratio must be compared to other similar companies in its industry.

It is important to note that the asset turnover ratio will be higher in some sectors than in others. For example, retail organizations generally have smaller asset bases but high sale volumes, creating high asset turnover ratios. On the other hand, businesses in sectors such as utilities and real estate often have large asset bases but low sale volumes, often generating much lower asset turnover ratios.

Example

Consider a company, Company A, with a gross revenue of $20 billion at the end of its fiscal year. The assets documented at the start of the year totaled $5 billion and the total assets at the end of the year were documented at $7 billion. Therefore, the average total assets for the fiscal year are $6 billion, thus making the asset turnover ratio for the fiscal year 3.33.

Another company, Company B, has a gross revenue of $15 billion at the end of its fiscal year. Its beginning assets are $4 billion, and its ending assets are $2 billion. The average total assets will be calculated at $3 billion, thus making the asset turnover ratio 5.

In this situation, it can be seen that Company B makes better use of its assets and generates revenue more efficiently than Company A. Therefore, stakeholders would find more benefits and less risk investing in Company B since its is more likely to produce a greater ROI.

How to improve the asset turnover ratio

Companies can attempt to raise their asset turnover ratio in various ways, including the following:

• Increasing revenue
• Improving inventory management
• Selling assets
• Leasing instead of buying assets
• Accelerating the collection of accounts receivables
• Improving efficiency
• Computerizing inventory and order systems

It is important for businesses to manage their fixed assets and other resources in order to maintain their optimal operational infrastructure and ensure that regulations are followed and production continues without interruption and without the loss of money during avoidable downtimes or other disruptions. Therefore, maintenance management within the company must concern itself with controlling costs, scheduling work appropriately and efficiently and confirming regulatory compliance.

Limitations of the asset turnover ratio

While the asset turnover ratio is a beneficial tool for determining the efficiency of a company's asset use, it does not provide all the detail that would be helpful for a full stock analysis.

Various other factors also limit the use of and reliance on the asset turnover ratio, such as the following:

• Artificial deflation can be caused by a company buying large amounts of assets, such as new technologies, in anticipation of growth.
• On the other side, selling assets to prepare for declining growth will result in an artificial inflation of the ratio.
• The outsourcing of production facilities will result in a much higher asset turnover ratio because the company will have a much lower asset base, thus making it appear more efficient than its competitors even if it is no more profitable.
• Seasonality greatly affects the ratio since the numbers drastically change throughout the year.
• A high turnover ratio does not necessarily mean high profits, and the true measure of a company's performance is its ability to generate profit from its revenue.
• A company's ratio can greatly differ each year, making it especially important to look at trends in the company's ratio data to find if it is increasing or decreasing.

Difference between the asset turnover ratio and the fixed asset ratio

While both the asset turnover ratio and the fixed asset ratio reveal how efficiently and effectively a company is using their assets to generate revenue, they go about it in different ways.

While the asset turnover ratio focuses on gross revenue and how much money is generated from every dollar of a company's total average assets throughout the fiscal year, the fixed asset ratio focuses on gross revenue and how much is generated for every dollar of fixed assets. In other words, while the asset turnover ratio looks at all of the company's assets, the fixed asset ratio only looks at the fixed assets. A fixed asset is a resource that has been purchased by the company with the intent of long-term use, such as land, buildings and equipment.