There are many tools at your disposal for analyzing your business’s sales performance. Ratios are one way to determine the efficiency of certain departments or assets — or even of your entire business.
You should be aware of the total asset turnover ratio when calculating income at the end of the year because it has significant implications for your business. Here’s what you need to know.
What Is the Total Asset Turnover Ratio?
The total asset turnover ratio of your business is a type of efficiency ratio that measures the value of your sales revenue in relation to the value of your company’s assets. It’s a tool you can use to measure how efficiently your company is using its assets to generate real revenue.
Most companies will want to see a high total asset turnover ratio because it means the company is effectively using its assets. In other words, it indicates your company is productive, efficient and generating little waste. It also indicates that your assets are still a value to your company and do not need to be discarded or replaced.
More specifically, you can use your total asset turnover ratio to determine the dollar value you’re receiving in sales compared to the dollar value of your assets.
The Total Asset Turnover Ratio Formula
Total asset turnover is represented as a relatively simple formula:
Total Asset Turnover = Net Sales / Total Assets
For example, if a company has $1 million in total assets and makes $100,000 in net sales, the formula would be the following:
Total Asset Turnover = $100,000 / $1,000,000
Total Asset Turnover = 0.1, or 10%
This means that the company’s assets generate 10% of net sales per their value. Another way to think of it is to assume every $1 in assets generates 10 cents in net sales revenue.
However, each component of this formula represents another formula in and of itself. You must calculate values for net sales and total assets separately if you intend to calculate total asset turnover using the above formula. Once you have these figures, just plug them into the formula to calculate your total asset turnover.
Here is how you can calculate the separate elements of this formula.
Calculating Net Sales
“Net sales” refers specifically to the sales revenue your company has earned after subtracting returns, allowances, discounts or any other losses. This makes it different than “gross sales,” which is the grand total of every sale transaction that occurred within a specific period, but without any subtractions.
Net sales are represented as a formula, which looks this:
Net Sales = Gross Sales – Returns – Allowances – Discounts
If your company has gross sales of $110,000, sales returns of $5,000, sales allowances of $3,000 and sales discounts of $2,000 in a period, this is the net sales formula calculation:
Net Sales = $110,000 – $5,000 – $3,000 – $2,000
Net Sales = $110,000 – $10,000
Net Sales = $100,000
Net sales are usually the figure your company would report in your income statement.
Calculating Total Assets
Total assets are the monetary value of all your business assets, including your liquid assets (cash), accounts receivable, fixed assets and your current assets.
Accounts receivable are the accounts on which your customers used credit to make purchases. They represent expected revenues, which count as an asset.
Fixed assets are usually physical things you’ve purchased for long-term use. This includes land, real estate, equipment or machinery. Fixed assets are assets that don’t get converted into cash.
Your current assets are assets you expect will be converted into cash within the coming year. These could include fixed assets that you expect to liquidate, or they could include accounts receivable or inventory you intend to liquidate.
Calculating your total current assets isn’t just an import step for determining your total asset turnover. It can help you determine your financial risk and help you make more informed decisions when it’s time to invest in new assets.
Your total assets are represented as a formula as well.
Total Assets = Cash + Accounts Receivable + Fixed Assets + Current Assets
For the sake of clarity, let’s use some simple — but somewhat unrealistic — numbers to understand how this formula works. Let’s say you have $100,000 in cash, $300,000 in accounts receivable, $500,000 in fixed assets such as land and machinery, and another $100,000 in current assets, which you expect to liquidate in the coming year.
With these numbers, the formula would calculate like this:
Total Assets = $100,000 + $300,000 + $500,000 + $100,000
Total Assets = $1,000,000
You’ve now determined that you have $1,000,000 in total assets. With numbers for both net sales and total assets established, you’re ready to calculate your total asset turnover ratio.
Putting the Formula Together
If you prefer, you could represent all these calculations as a single formula. It would look like this:
Total Asset Turnover = (Gross Sales – Returns – Allowances – Discounts) / (Cash + Accounts Receivable + Fixed Assets + Current Assets)
Since we already have numbers for these values, we can go ahead and plug them in to reproduce our very first calculation:
Total Asset Turnover = $100,000 / $1,000,000
Total Asset Turnover = 0.1, or 10%
To apply this to your own company, all you need to do is assign the relevant numbers from your books to each of the values represented above.
How to Interpret the Total Asset Turnover Ratio
When you’re running a business, generating revenue is a primary concern. Knowing this, it’s important that all your business assets — whether they’re fixed assets or otherwise — are contributing value to your business by generating revenue.
The best way to interpret your total asset turnover ratio is as an efficiency rating for your business assets. If your ratio is low, it means at least some of your assets are not contributing enough to revenue generation. This might mean it’s time to fix, replace or liquidate some of your assets to become more efficient.
For example, if you’re in manufacturing, fixed assets — such as machines — lose value over time. This will cause your total asset turnover ratio to fall; especially if those machines require costly repairs or replacement parts to continue running. If the cost of maintaining a building or a plot of land has gone up, or if the value of that real estate has gone down, this could diminish your ratio.
Likewise, an abundance of discounts and returns would lower your net sales number and decrease your ratio. This could indicate an issue on the sales side of your business because it appears that you’re accommodating unhappy customers.
How Does the Total Asset Turnover Ratio Impact Your Business?
Most businesses use this ratio to determine whether they’ve increased or decreased efficiency in each period. It’s best to calculate total asset turnover at least every year so you can compare the numbers and identify yearly trends.
If your ratio is going down, it may be time to do an analysis of your sales processes and the status of your current assets. You may need to make new investments in order to raise your ratio, but depending on what you find, it could mean you need new sales processes or even a new product.
