The success of your small business largely depends on your management of working capital. But working capital doesn’t just mean cash. By definition, the term working capital refers to all assets currently available for covering business expenses or operational costs. In other words, it’s not how much cash you have that matters. It’s the value of your business’s assets and how you use them. The asset turnover ratio formula determines your asset management’s efficiency or assets’ ability to generate sales.
Much like the concept of cash flow, this figure compares your sales’ dollar value to the dollar value of your current and fixed assets. Your asset turnover ratio might also come up when you’re looking to secure additional business funding or small business loans.
In this guide, we’ll explain how to calculate your asset turnover ratio, why you need to know this figure, and what you can do to improve it.
In this guide, we’ll answer the following questions and more:
- What Counts As Current or Fixed Assets?
- What Is the Asset Turnover Ratio Formula?
- Why Should I Know My Asset Turnover Ratio?
- What Is a Good Asset Turnover Ratio?
- How Can I Improve My Asset Turnover Ratio?
What Counts As Current or Fixed Assets?
It’s only natural to find the term “assets” confusing. Different business owners and finance professionals tend to have different definitions for what constitutes current or fixed assets. We’re going to use the most generally accepted definitions in this guide.
According to the general definition, current or “liquid” assets refer to cash and anything you can convert to cash within one year’s maximum span. Examples include inventory, outstanding accounts receivables, or stock the business holds in another company. This differs from fixed or “long-term” assets, which refers to assets that you cannot easily convert into cash within one year. This can include real estate, equipment, copyrights, etc.
Understanding the difference between current and fixed assets can prevent you from having too much money tied up in the latter variation. This would significantly decrease your working capital. It would be best if you instead strived for an equal balance between the two.
What Is the Asset Turnover Ratio Formula?
All businesses strive to improve efficiency in multiple areas. When it comes to assets, efficiency means using them to produce as many sales as possible or simply making the most out of every type of asset in your possession.
Here’s how to find your asset turnover ratio:
Net Sales / Average Total Assets
Most businesses strive for an asset turnover ratio of >1 and use annual numbers for the equation.
However, certain factors, like industry and company size, can slightly alter the kind of ratio your business should shoot for.
Where to Find Your Net Sales
Your income statement (or profit and loss statement) contains your net sales number. It would help if you used this figure instead of your gross sales because this figure accounts for returns, discounts, damaged products, or anything that decreases the amount of money generated from certain sales. Since you use assets to make sales, those factors also reduce the value generated by the asset involved. In summary, net sales provide the most accurate picture of how your products performed throughout the year.
Where to Find Your Average Total Assets
Average total assets refer to the average value of your current and fixed assets over two years. You can obtain the information required for this figure on your balance sheets from the current year and prior. Then, add the two numbers and divide the total by two.
Once you’ve found your net sales and average total assets, divide the former by the latter to produce your ratio. That’s it!
Asset Turnover Ratio Formula Example
Let’s apply the asset turnover ratio formula with the following numbers:
- Current year’s total sales: $300,000
- Returns, damages, and lost inventory: $6,500
- Current year’s assets: $60,000
- Prior year’s assets: $30,000
Asset Turnover Ratio = Net Sales / Average Total Assets
($300,000 – $6,500) / ($60,000 + $30,000/2)
$293,500 / $45,000
Asset Turnover Ratio = 6.5
For every $1 spent on assets, the hypothetical business generates approximately $6.50.
Why Should I Know My Asset Turnover Ratio?
Many business owners view the asset turnover ratio as yet another tool for learning more about cash flow and profitability. This makes sense since both figures deal with the cost of generating revenue. Improving your ratio will, therefore, likely improve cash flow and profitability. If you wanted to determine why your business’s cash flow or profitability has improved or dwindled as of late, you might consider examining your asset turnover ratio.
Financial institutions might look at your asset turnover ratio when mulling over your application for business funding. After all, institutions usually search for as much evidence as possible to solidify an applicant’s positive cash flow. Additionally, this information will tell institutions that the company’s leader knows exactly how to keep that cash flow in good shape.
The formula could also play an especially prevalent role for younger businesses seeking small business loans. These businesses might not have the highest revenue. But their ratio could show that they have the management skills to get there.
What Can Skew Your Asset Turnover Ratio?
Unlike other critical financial figures, most businesses only measure their asset turnover ratio once per year. Thus, making just one or two large purchases within that time frame can significantly skew your current ratio. And as any experienced business owner knows, it’s extremely common for businesses to suddenly have to put up various large sums of cash for necessary expenses. Examples include equipment, new employees, renovations, or other conventional startup costs.
These expenditures can profoundly affect your asset turnover ratio, even if they occurred several months before doing your calculations. In such cases, your ratio would not accurately reflect the overall efficiency of your business.
What Is a Good Asset Turnover Ratio?
Again, every industry has its standards for asset turnover ratios. But while the specific benchmark might differ from business to business, virtually all companies follow the same logic: higher = better.
The higher your ratio, the more money your business generates from its assets on average. Earlier, we established the general goal of >1. That “1” represents $1. So, as long as your asset turnover ratio meets this benchmark, the dollar value generated from your assets exceeds the dollar value of their cost.
Let’s say one business has an asset turnover ratio of 1.5, while another has an asset turnover ratio of just 0.5. This means that the first business generates $1.50 for every $1 spent on its assets. The other business, on the other hand, makes just $0.50 for every $1. For some reason, the average dollar value generated by the other business’s assets does not exceed these assets’ average dollar value. It’s now up to the business owner to find the source of the problem.
The industries with the highest benchmarks typically have lots of current assets and high turnover rates for products in general. In retail, for example, most businesses strive to get their ratios closer to 2. Service-based companies, on the other hand, generate revenue at a much slower pace. Even the most successful service-based companies likely could not match the retail benchmark. Hence, trying to meet another industry’s benchmark could end up doing more harm than good.
How To Improve Your Asset Turnover Ratio:
Earlier, we mentioned the direct connection between asset turnover ratio, profitability, and cash flow. So, if you wish to improve that first figure, look for the most effective strategies for improving the other two. This includes generating more sales, decreasing the cost of goods sold, and stronger inventory management.
Specific, less obvious strategies, however, may improve your asset turnover ratio faster than others. We’ll lay those out right here:
1. Add New Products or Services That Don’t Require Assets
Sometimes, trying to sell more of your existing products or services doesn’t work out. One solution is to open up new revenue streams. If possible, explore products or services that don’t require an investment. Selling something new that doesn’t involve spending more money on assets will likely boost your ratio.
2. Move Unsold Inventory
The longer inventory sits on your shelves, the more it affects your ratio. Yes, you may have to sell the items at lower prices and lose money. But this minor drop in profitability cannot compare to the damage you’ll take if you let the items go unsold.
3. Minimize Returns
Minimizing returns increases your net sales, which then increases your asset turnover ratio. You could accomplish by keeping tabs on customer satisfaction so you can address potential problems that may result in returns. Another option is distributing store-credit, which allows you to keep sales revenue even if it is returned.
Putting Your Asset Turnover Ratio To Good Use
All in all, a good asset turnover ratio essentially means that you are investing in the right assets or using the right resources to make sales. It’s tough (if not impossible) to run a successful business without doing this. So, when you and your accountant are trying to figure out why your business isn’t performing as well as it should, consider your asset turnover ratio. It may turn out to be the explanation you are looking for.