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 the efficiency of your asset management, or your assets’ ability to generate sales.
Much like the concept of cash flow, this figure compares the dollar value of your sales 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.
But first, let’s clarify the definition of current and 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 refers to cash and anything that you can convert to cash within the maximum span of one year. 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’s time. 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. You should instead strive for an equal balance between the two.
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.
Certain factors like industry and company size, however, can slightly alter the kind of ratio your business should shoot for.
Your income statement (or profit and loss statement) contains your net sales number. You should use 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 decrease the value generated by the asset involved. In summary, net sales provide the most accurate picture of how your products performed throughout the year.
Average total assets refers to the average value of your current and fixed assets over the span of two years. You can obtain the information required for this figure on your balance sheets from the current year and the year prior. Then, simply add the two numbers and divide the total by two.
Once you’ve found your net sales and average total assets, just divide the former by the latter to produce your ratio. That’s it!
Again, every industry has its own standards for asset turnover ratios. But while the exact benchmark might differ from business to business, virtually all businesses 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 binary options demo accounts generates $1.50 for every $1 spent on its assets. The second business, on the other hand, generates just $0.50 for every $1. For some reason, the average dollar value generated by the second business’s assets does not exceed the average dollar value of these assets. 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. Since service-based businesses tend to generate revenue at slower paces, even the most successful companies likely could not match the retail benchmark. Hence, trying to meet another industry’s benchmark could end up doing more harm than good.
Let’s apply the asset turnover ratio formula with the following numbers:
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.
Many business owners view 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 they can find to solidify an applicant’s positive cash flow. Additionally, this information will tell institutions that the leader of the company 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 clearly have the management skills to get there.
Unlike other important 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 multiple large sums of cash for
necessary expenses. Examples include equipment, new employees, renovations, or other conventional startup costs.
These expenditures can heavily effect your asset turnover ratio even if they occurred several months before you do your calculations. In such cases, your ratio would not accurately reflect the overall efficiency of your business.
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.
Certain, less obvious strategies, however, may improve your asset turnover ratio faster than others. We’ll lay those out right here:
Sometimes, trying to sell more of your existing products or services just 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.
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.
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 the item is returned.
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 very difficult (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.
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