Analysing Asset Turnover Ratio

Prudent investors use fundamental analysis and technical analysis to glean investments that have the potential for capital preservation and/or capital appreciation.

Simply put, fundamental analysis consists of scrutinizing the balance sheet, income statement, and the statement of cash flow with the hope of gaining valuable insight into a company's future performance.

Calculating and analyzing financial ratios, viz., liquidity, profitability, operating performance, cash flow indicator, investment valuation, and debt ratio, is important to form a sound judgment regarding investments. Here, we deal with commonly used operating performance ratios, which includes the Asset turnover ratio.

Total Asset Turnover Ratio: It is used to measure operating performance. It is defined as the ratio between net sales and total assets. It measures the revenue that is generated for every dollar of asset owned by the company. The formula is as follows:

Total Asset Turnover Ratio = Net Sales_n / Average Total Assets

Where:
Total Assets = Liabilities + Shareholders' Equity
Average Total Assets = Total Assets_n + Total Assets_n-1
n = Year

Fixed Asset Turnover Ratio: It measures the revenue that is generated by the company/management per dollar of fixed assets. The formula is as follows:

Fixed Asset Turnover Ratio = Revenue_n / Average Fixed Assets

Where:
Fixed Assets refer to Property, Plant and Equipment
Average Fixed Assets = Fixed Assets_n + Fixed Assets_n-1
n = Year

Asset turnover ratios help to measure the effectiveness with which the company/management uses its assets to generate sales or revenue. These ratios help to measure the productivity of a company's assets.

A high ratio is desirable as compared to a low ratio since the former is indicative of better operating performance. It also symbolizes greater shareholder wealth.

Total assets include current assets, fixed assets, and intangible assets, such as licenses and goodwill. Fixed assets entail huge initial investments that are undertaken with the hope of maximizing revenue. Hence, the fixed-asset turnover ratio is a better measure of operating performance as compared to the total asset turnover ratio.

The amount of capital investment varies depending on the type of business. For instance, oil production and refining and the telecommunications industry is highly capital intensive while the restaurant business or for that matter, agriculture, is labor intensive.

The proportion of labor costs in relation to the capital required, for producing a given volume of goods and services, is used to determine whether the process is labor intensive or capital intensive.

Fixed-asset turnover ratio is more relevant for capital intensive industries, since the size of the fixed asset base depends on whether the process of production is labor intensive or capital intensive.

In general, companies that are labor intensive have a higher fixed-asset turnover ratio as compared to companies that are capital intensive. Hence, one should compare firms within the same industry rather than comparing them across industries to get a true picture of a firm's relative operating performance.

One should also compare a firm's past performance with the current performance for a better understanding of the company's prospects.

Net Profit Margin is a measure of profitability and is defined as the ratio between Net Income and Revenue.

Net Profit Margin = Net Income / Revenue

An inverse relationship exists between profit margin and turnover ratio. For instance, if the net profit margin is high, revenue or net sales will be low, thus resulting in a low turnover ratio.

Calculating the asset turnover ratio is simple, since its calculators are available online. Along with this ratio, a number of other financial ratios have to be examined before deciding on whether to buy stocks or refrain from investing in the company. In other words, financial statement analysis is indispensable for choosing the most suitable investment.