Understand the secret to business efficiency with the Asset Turnover Ratio. Is a company’s assets working hard or gathering dust?
While assessing any company, we primarily want to analyse how stable the company is. Hence, we ask a few questions: Can the company generate good profits for the investors compared to its competitors, or can it manage its short-term liabilities on time? Similarly, we look at several ratios to understand the company’s performance and analyse its financial health.
Today, we will look at one such ratio to help you analyse how efficiently a company uses its assets. We are talking about the Asset Turnover Ratio.
What is the Asset Turnover Ratio?
The Asset Turnover Ratio is a key financial metric that measures a company’s ability to generate revenue from its assets. In simple terms, it tells us how efficiently a business uses its assets to produce sales.
The formula to calculate the Asset Turnover Ratio is:
Asset Turnover Ratio = Average of Total Assets/Net Sales.
- Net Sales refer to the total revenue generated by the company after deducting returns, allowances, and discounts.
- Average Total Assets are the average value of all assets (both current and non-current) employed by the company during a fiscal year.
Suppose your business has revenues of Rs 1,00,000 and total assets of Rs 50,000. In that case, the asset utilisation ratio will be 2:1. This means that your operations generate Rs 2 in revenues for every Re 1 you have in assets.
So, the higher the ratio, the better, as it signifies that the company effectively uses its assets to generate revenue. Conversely, a lower ratio may indicate inefficiencies in asset management or an underutilisation of assets, adversely affecting a company’s profitability and financial health.
Let’s look at the asset turnover ratio of refinery companies.
Among the major players in the energy sector, Mangalore Refinery and Petrochemicals Limited (MRPL) stands out with the highest asset turnover ratio at 2.90, signifying exceptional efficiency in converting its assets into revenue. In contrast, Reliance Industries lags significantly with an asset turnover ratio of 0.56, suggesting a comparatively less efficient utilisation of its assets when compared to its competitors, namely Indian Oil Corporation Limited (IOCL) with a ratio of 1.97, Bharat Petroleum Corporation Limited (BPCL) with a ratio of 2.52, and Hindustan Petroleum Corporation Limited (HPCL) with a ratio of 2.79.
Importance of Analysing Asset Turnover Ratio
Usage of Assets for Generating Profits
The Asset Turnover Ratio helps us see how well a company uses its assets to make profits. If the assets are just gathering dust and not helping bring in revenue, it is similar to having a car parked in the garage and never taking it for a drive. In short, unused assets would just add maintenance costs without giving anything back.
So, this ratio tells us if a company’s assets are working hard to make a profit for you and the company or if they are just sitting in the corner and costing money.
Helps in Finding the Efficient Company in the Sector
Investors find the Asset Turnover Ratio particularly handy because it lets them put companies side by side and see who is doing a better job turning assets into sales. Apart from this, you can also analyse which company might need to step up their asset management game to keep up with the competition.
Understand if a Company is Making Efforts to Become Efficient
Tracking trends of the Asset Turnover Ratio helps investors understand if the company’s efforts and strategies to use assets more effectively are paying off. But if the ratio starts to drop, it signals that something is not working as efficiently as before or the business landscape is changing.
This ratio acts as a compass, helping investors understand what is happening in the business.
Avoiding Unnecessary Risk
When a company’s Asset Turnover Ratio is on the lower side, it is like a red flag for investors. It signals that the company might be in rough waters financially. It suggests the company may have trouble meeting its financial commitments and staying afloat. That is why investors tend to see companies with low asset turnover as riskier bets.
Limitations of Asset Turnover Ratio
1. Ratio Can Be Misleading if Large Asset Purchases are Made For Future Vision
Sometimes, a company may decide to make substantial investments in assets, such as acquiring new technologies to support the future vision of the company.
While this investment can be crucial for future success, it can temporarily lower the Asset Turnover Ratio, giving the impression of reduced efficiency.
The truth is that these investments may initially weigh down the ratio, but their long-term benefits can lead to more efficient operations and higher revenues in the future.
2. Artificial Inflation of Asset Turnover Ratio
Companies even sell off assets, especially when a company anticipates slower growth or a shift in its focus. This can create artificial inflation in the Asset Turnover Ratio and may give the illusion of superior efficiency.
Therefore, it is important to scrutinise the reasons behind the changes in the trend of the ratio and consider whether they align with the company’s long-term strategy before drawing conclusions.
3. If the Company Outsources Projects
When a company decides to outsource its production facilities, it can significantly impact its Asset Turnover Ratio. Outsourcing often means a reduced asset base because the company no longer owns the physical assets used for production. This can result in a higher asset turnover ratio on paper since the denominator (average total assets) decreases.
However, it is crucial to remember that a higher asset turnover ratio doesn’t automatically equate to profitability or efficiency.
In such cases, evaluating the company’s overall financial health and profitability through other metrics is necessary.
4. Seasonality Influence
Seasonal fluctuations can substantially impact a company’s Asset Turnover Ratio, making it challenging to gauge overall efficiency accurately. For example, if a retail business experiences a surge in sales during the holiday season but slower sales during the rest of the year. During the peak season, the company’s assets may seem exceptionally productive, leading to a higher asset turnover ratio. However, this ratio may drop significantly during off-peak periods.
This seasonality can create similar ups and downs in the ratio, but it doesn’t necessarily reflect the company’s efficiency over an entire year.
These limitations remind us that while the Asset Turnover Ratio is a valuable tool, it is essential to consider it in the broader context of a company’s financial health and strategy.
To conclude, the asset turnover ratio is a critical measure of a company’s efficiency in generating revenue from its assets. It is a major guide for investors in assessing the company and making informed decisions.
Investors must also look at other ratios like profitability, liquidity and solvency ratios to understand the company better.
*The companies mentioned are for information purposes only. This is not an investment advice.