When your company needs to find out how effective its assets are at producing revenue, you’ll need to know how to calculate asset turnover.
Calculating your asset turnover will help your company identify large inefficiencies and give your departments some ideas on what to improve.
In this article we’ll explain why asset turnover is an issue you should be concerned about, and then show you how to calculate asset turnover.
By the end, you’ll have a few tricks up your sleeve and have a good understanding of when asset turnover is a relevant metric to consider and when it’s deceptive or overblown.
What Is Asset Turnover?
Asset turnover is a ratio of revenues to the average total value of assets. For every dollar in revenue that a company makes, that company likely spends some amount on assets.
For example, a lemonade stand might have $50 in assets, and spend an additional 5 cents to produce each lemonade which is subsequently sold. If the lemonade stand makes $1000 in revenues after a day of sales, it has a high asset turnover.
Small asset valuation is sufficient to make the lemonade stand a huge amount of revenue in comparison to the cost of producing lemonade.
If you had to choose between investing in that lemonade stand or one which only made $500 with the same amount of starting capital, you’d probably pick the first one.
Higher values of asset turnover indicate that a company can produce more revenue by spending less money. There’s never a reason for a company to desire a lower asset turnover.
In contrast, lower values of asset turnover indicate that a company struggles to produce value from utilizing their assets.
Alternatively, companies with lower asset turnover may be growing in response to demand, but there may be a lag between when the company invests the effort into procuring new capital and when that capital starts to offer returns.
Once the capital starts to offer returns, the company’s growth efforts will pay off, and the asset turnover will rise.
For some industries, this is extremely important because capital may need to be procured for years before any revenues are produced. You would expect these companies to have chronically low asset turnover values even if they’re broadly profitable.
For investors, companies with high asset turnover ratios are appealing because they can do more with less. Conversely, businesses with low asset turnover may struggle with revenues or with high operating costs.
Making The Asset Turnover Calculation
You can choose to perform the asset turnover calculation over any period that you desire, but the most common is to calculate it for a year’s worth of assets and revenues. If you deviate from this standard, be sure to make a note of it so that nobody gets confused.
How to calculate asset turnover for your company is very easy.
First, take the value of all of your company’s assets. If you have three assets valued at $10, $20, and $30, your total asset valuation would be $60.
Once you have the total asset valuation, find the average value of your assets. In our example company, this means that you would take your total asset value, $60, and divide it by 3 to get the average, which is $20.
Upon calculating the average asset value, it’s time to consider revenues. Let’s assume that our example company’s revenues are $1000 per year. Keep in mind, you shouldn’t be subtracting expenses or doing any other calculations. Stick to the revenues.
Take the revenues, and divide them by the average cost of assets. This means that we should take $1000 and divide it by $20, leaving us with an asset turnover of 50. Not bad.
If you’re interested in finding out the amount that an individual asset or group of assets contributes to your company’s revenues, you can do that with this same calculation.
Just treat the average asset value as the group that you’re interested in. Find the percentage value of that asset in terms of your total assets, and multiply that against your revenues.
Performing this calculation will give you a lot more insight into how your assets contribute to your revenues. Some classes of asset — like raw materials — will have a very high asset turnover when considered in isolation.
Don’t go too crazy when it comes to considering assets in isolation, though. Your company needs all of them working in tandem to function.
When To Beware Using Asset Turnover As A Metric
Asset turnover isn’t the ultimate business statistic, however. Like with all other metrics, you need to interpret the asset turnover of a company in the context of its scale, the sample size, and the absolute values being discussed.
The lemonade stand example is deceptive because you would be hard-pressed to find an investor who would invest in any lemonade stand regardless of its asset turnover.
The scale of the lemonade stand is very small, and so a large asset turnover value might not be reproducible if that assets are continuously added.
For example, if you gave the owner of the lemonade stand $1000 to invest in assets for their business, it would be extremely shocking if the high asset turnover persisted into the next year.
The business concept of a lemonade stand is very difficult to scale with the addition of asset value, which means that the value itself isn’t nearly as important as it might seem to the perspective of the investor.
Likewise, our example lemonade stand was only in business for one year — but that means it could have been a blip. Investors are wary of jumping into opportunities which aren’t durable sources of profit.
For our lemonade stand, there might have been other economic factors or business factors which made that one year especially profitable. Investors need context before it’s worthwhile because most businesses can be profitable for one year — often at the expense of their future years.
Extremely high asset turnovers may be a red flag for them because they might indicate a lucky break or intentional gaming of the numbers by selling off assets before making the calculation.
The sample size is number of years for which you calculate asset turnover. You could even do a meta-calculation of average asset turnover over the course of a decade.
Navigating To A More Efficient Business
Now that you’re equipped with a bit of background about asset turnover and how to calculate it, it’s time to apply the concept to your company — or, perhaps, your investment opportunities.
Remember to clarify which assets you’re including in your calculation, which duration of time you’re performing the calculation over, and whether the final value is notable given the context of your business’ scale, history, and absolute dollar values.
When you have your calculation in hand and think that your company has something notable going on, you’ll be eager to head to the investors or the boardroom to show them what you’ve been doing.