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Are you managing your business’s assets as efficiently as possible? The asset turnover ratio can help you figure this out.
Asset turnover ratio is one of the most crucial business equations and accounting formulas to know. Not only will this figure help you understand if you should tweak your processes (like production, for instance) to optimize your sales, but it’ll also give you a sense of whether you’re performing your best as a manager. Plus, the asset turnover ratio can come in handy when you’re looking into business funding.
We’ll show you how to calculate the asset turnover ratio equation, and why it’s important to know. Then, we’ll review a few ways to improve yours.
Your asset turnover ratio is an equation to help you figure out how you’re using your assets to generate sales. In much simpler terms, you can figure out how many dollars of sales you’re generating for every dollar in assets you have. This formula is a peek into the efficiency of your business—whether or not you’re using the assets you have, both fixed and current, to generate sales.
Well, hopefully you do. This ratio indicates whether or not you’re efficiently managing—and optimizing—your assets to produce the highest volume of sales possible. You want to maximize your output with as little input as possible, so this is a crucial number to know.
But you’re not the only one who can benefit from understanding your asset turnover ratio. If you’re a small business looking for business financing, or applying for any type of credit product, it’s possible that this ratio could come into play during the application process. That’s because this ratio gives creditors a direct line of sight into whether or not your company is optimally managed.
Similarly, investors will be very interested in this metric. As a startup seeking early-stage investment, if your company has low revenue, venture capitalists will be taking a gamble on you. Any stats that indicate your strong management can only help!
The asset turnover ratio is generally calculated annually. To find yours, use this simple formula:
Net Sales / Average Total Assets
You can locate your net sales number on your income statement (also known as your profit and loss statement). What goes into that net sales figure? This is your total sales number, minus any returns, damaged goods, missing goods, etc. Rather than gross sales, your net sales is the more accurate figure to use when you’re generating your asset turnover ratio. Remember that net sales only accounts for the products that end up in your customers’ hands at the end of the year—in other words, what they actually paid for.
This figure represents the average value of both your long- and short-term assets over the past two years. To reach this number, you’ll need (unsurprisingly) two years of asset totals; you can find this information on your balance sheet. Once you have your current year number and your previous number, add them up and divide them by two for the average.
Generally, “good” is a relative term in business (as it is in life). So, what makes a good asset turnover ratio for your business isn’t necessarily the same as your neighbor’s. In fact, every industry has its own benchmarks, and you’ll want to check yours to see if you’re getting the most out of your assets.
That said, you should understand what your number indicates in a vacuum, too. All told, for the asset turnover ratio, the higher, the better. A higher number indicates that you’re using your assets efficiently. For instance, an asset turnover ratio of 1.4 means you’re generating $1.40 of sales for every dollar of assets your business has. A ratio of 0.4 means you’re only generating $0.40 for every dollar of assets you have.
Some sectors, like retail, will more likely see a good ratio around 2. Others, particularly that are service-based, will have a much lower ratio. That’s why it’s especially important to know what’s relevant to you. You don’t want to be judging yourself on a metric you set yourself—especially when it’s one that’s meant to help you improve your business.
Let’s apply the asset turnover ratio formula with the following numbers:
Asset Turnover Ratio = Net Sales / Average Total Assets
Asset Turnover Ratio = ($100,000 – $3,500) / ($40,000 + $25,000/2)
Asset Turnover Ratio = $96,500 / $27,500
Asset Turnover Ratio = 3.5
In this case, this business is making $3.50 for every dollar of assets.
As with any business, you’ll find that you need to invest in different purchases at different times. One year, for instance, you might be very heavy on startup costs, which reduces your cash on hand; another, you might go on a hiring spree and have to buy, say, new computers for all your new employees (not to mention your need to cover payroll).
Since asset turnover ratio is only measured once per year, you’ll have to understand that large purchases, even if they were made months ago, can easily skew your current ratio. So, you might find that your asset turnover ratio isn’t a totally accurate reflection of your current efficiency.
Hopefully, though, those big-ticket purchases and investments are in service of your infrastructure and workforce, so will end up improving your asset turnover ratio in the long run.
Want to get your asset turnover ratio in a better place? Good instincts. You can approach this by addressing a few different areas of business:
Since sales is one whole side of your ratio, you’ll need to focus much of your efforts on boosting this number. Easier said than done, of course. But here are a few considerations to use as a jumping-off point to alter your sales processes:
Tighter control of inventory, including returns and damaged goods, will help you bring up your net sales number.
You want to generate more with less, right?
Although there’s no single key to a successful business, it’s often the business owners who’ve figured out how to run a lean business who enjoy long, prosperous futures. Your asset turnover ratio will help you understand whether or not your business is running efficiently and, subsequently, whether you’re setting it up for success.
But even if your asset turnover ratio number isn’t where you want it to be, don’t worry—that number isn’t set in stone. If you can make adjustments in your processes to improve that number, that’s great news—it shows that you’re a flexible owner, and can make changes to benefit your business.