One of the most important questions for investors is how efficiently a company uses its assets generate revenue. This information is not readily found in the most common financial reports, such as balance sheets. The performance numbers of a large business may hide otherwise poor performance. This obscurity sometimes plagues legacy firms that may not have adapted well over the years but which have significant wealth on which to coast. On the other hand, a small but well-run general partnership, for example, can nevertheless look like a poor investment based on its share price or relatively modest assets. As a result, stock investors have developed metrics such as the asset turnover ratio (ATR) to gauge how efficiently a company uses its assets to bring in revenue.
Calculating Asset Turnover Ratio (ATR)
The ATR is calculated as the company’s net sales over a period of time against its average assets over that same period:
- ATR = Net Sales / Average Assets
- Net sales are the total sales over a period of time after accounting for any returns, discounts or other price reductions. (Some investors will also deduct the costs of any good sold from “net sales,” but this is less common.)
- Average assets is the average value of all of the company’s assets over the period being considered. So, if you are trying to determine a company’s ATR over a calendar year, you would add its total assets on Jan. 1 to its total assets on Dec. 31 and divide by two.
For example, we could provide the following ATR analysis on XYZ Corp.:
- Time period: 1 year
- Net sales over 1 year: $250,000
- Total assets at start of year: $190,000
- Total assets at end of year: $202,000
The formula would then be:
- ATR = Net Sales / Average Assets
- ATR = $250,000 / [($190,000 + $202,000) / 2]
- ATR = $250,000 / ($392,000 / 2)
- ATR = $250,000 / $196,000
- ATR = 1.27
XYZ Corp. has an ATR of 1.27.
Interpreting Asset Turnover Ratios
It’s most common to calculate a company’s ATR annually. This is particularly true for any business that might be seasonally impacted. For example, most “fast fashion” retail operations will experience surges during certain times of the year such as December and August. A more narrow ATR analysis may either leave those out or give them too much weight.
A higher ATR is generally considered the sign of a strong business model. This means that the company is earning more money on every dollar of assets than its peers. For example, at time of writing the average ATR for the retail sector was 1.78. A retailer with an ATR of 2.01 would, therefore, likely be a sound investment as it is making more money per dollar owned than the average competitor.
By contrast, a lower ATR shows the opposite. This indicates that the company is using its assets more inefficiently and generating less money per dollar invested than its industry peers. In our retail example above, a business with an ATR of 1.5 would likely be a weak investment, as it is underperforming compared to other similarly situated businesses.
There is some subjectivity in interpreting a corporation’s ATR. It is used to compare either two companies against each other or a single company against the average expectations of its industry. It is essential to compare companies only in comparable industries or practice areas. This is because asset requirements differ among various industries. A law firm, for example, requires very few underlying assets, allowing even relatively mediocre ones to enjoy high ATR scores. By contrast a thriving construction firm will have a far lower ATR due to its significant infrastructure investments, even if it is more efficiently run.
Note that in some industries it is common for a company to produce an ATR of less than 1.0. This does not mean that the company is unprofitable, simply that it produces less than $1 of revenue for every $1 it has in total assets. In some fields, such as retail, this might indicate serious structural problems, but it’s far more common among industries with large physical investments, such as manufacturing and real estate companies.
The ATR is a metric, closely followed by many investors, indicates how efficiently a company brings in revenue for every dollar it has in assets. It is calculated by dividing the net sales of the business by its average assets. A relatively high turnover ratio indicates a business that is generally effective at converting assets into revenue, while a relatively low ratio indicates the opposite. This metric, which should be used to compare companies within the same sector or industry, is typically calculated for a one-year period, though shorter periods, such as months or quarters, are sometimes used.
Tips for Investing
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- If you’re studying investment metrics, there is arguably no piece of data more influential than the price-to-earnings ratio. This formula has been relied on by generations of investors to help them pick their stocks, and now you can understand it, too.
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