Asset turnover is the measure of how effectively a company uses its investment in its assets, like inventory, accounts receivables, and fixed assets, to increase its sales revenue. Asset turnover ratios tell a business owner how well they are managing their assets.
What Are Sales-Generating Assets?
If you look at the left side of a balance sheet, you find your company’s investment in assets:
|Total Current Assets||$|
|Net Fixed Assets||$|
The company’s assets are listed in the order of their liquidity or the ease with which they can be converted to cash. The first three assets on the balance sheet are a company’s current assets since the assumption is that they will be liquidated within one year. Cash, the first asset listed, is already perfectly liquid. It is also not a sales-generating asset. The only other number you need to calculate the asset turnover ratios is Sales and it can be taken from the income statement.
Accounts receivable is generally the second asset listed on the balance sheet. Receivables are less liquid than cash since customers must pay your company to liquidate the receivables.
Inventory is listed on the balance sheet after accounts receivable for companies that sell products. Inventory is less liquid than cash or accounts receivables because companies must find customers must find buyers for their products.
Fixed assets, or plant, property, and equipment, are not a current asset. They are the least liquid of all the assets and are a permanent part of the company’s asset base.
What Level of Assets Should a Company Have?
If a company has a large investment in the three types of assets that generate sales, its operating capital may be too high. This will reduce its free cash flow and, in the long run, it will reduce its stock price.
If a company has a low investment in its sales-generating assets, it will lose sales, and this will hurt its profitability and stock price.
It’s important to have the right amount of investment in sales-generating assets, not too high or too low, to have optimal asset turnover. The asset turnover ratios help the business owner determine the right amount of asset investment.
For any of the financial ratios to make sense, business owners should have something to compare them to. They can use data from other companies in their industry or data from previous time periods of their own company. The former is industry analysis and the latter is time-series or trend analysis.
BizStats offers industry ratios for 250 industries and there is a section specifically for sole proprietorships. You get the data for time-series ratio analysis from your balance sheets and income statements.
Evaluating Accounts Receivable
There are two financial ratios that help a small business owner evaluate their investment in receivables and their credit policy regarding asset turnover. The first receivables ratio is the Average Collection Period (ACP). It tells the business owner, on average, how many days it takes them to collect their credit balances from their customers.
Average Collection Period = Accounts Receivable/Average Sales Per Day (from the Income Statement)
= # of Days
The receivables turnover ratio is another ratio that helps the small business owner evaluate receivables and credit policy. It tells the owner how quickly credit accounts are being collected and if the business is offering too much of a discount for paying in advance.
Receivables Turnover = Sales/Accounts Receivable (where Sales comes from the income statement)
= # of times per time period measured
If the Average Collection Period is too high or the Receivables Turnover is too low, then the company may not be using its accounts receivable effectively to generate sales. Credit accounts are not being collected fast enough.
Credit accounts are being collected too slowly if the ACP is too low or the Receivables Turnover is too high. You can only make these determinations by comparing your results to industry or time-series information.
Inventory turnover is one of the most important asset turnover ratios. This is because it evaluates how well the company’s products sell. If the inventory turnover ratio is too low, then the company is not selling its products well and is holding obsolete inventory. If the ratio is too high, the company is likely to stockout of inventory, which will damage customer goodwill.
Inventory turnover = Sales/Average Inventory
= # of Times
It is important to use the comparative industry and time-series data to evaluate the inventory turnover ratio.
Evaluating Fixed Assets
The fixed assets turnover ratio evaluates how well a company uses its investment in plant and equipment to generate sales. If the ratio is declining, the business may be over-invested in fixed assets. If the ratio is increasing, then the company may not have enough plant and equipment to support its level of sales.
Fixed Asset Turnover = Sales/Net Fixed Assets (where Sales comes from the Income Statement)
= # of Times
The fixed asset turnover ratio varies widely between industries. It’s important to compare the ratio for your company's industry to the results for other companies in your industry.
The Bottom Line
The total assets turnover ratio combines your company’s investment in accounts receivable, inventory, and total assets and divides them into sales. This ratio determines if your company is generating enough business given its total asset investment.
Total Asset Turnover = Sales/Total Assets (where Sales come from the Income Statement)
= # of Times
This ratio should be compared to industry data. If it is low comparatively, then sales should be increased or assets sold. If it is high, the opposite actions should be taken.
Using asset turnover financial ratio analysis can help your company stay solvent and competitive by effectively using its assets to generate sales.