The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue.
The numerator of the asset turnover ratio formula shows revenues which is found on a company's income statement and the denominator shows total assets which is found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated. For example, if a company is using 2009 revenues in the formula to calculate the asset turnover ratio, then the total assets at the beginning and end of 2009 should be averaged.
It should be noted that the asset turnover ratio formula does not look at how well a company is earning profits relative to assets. The asset turnover ratio formula only looks at revenues and not profits. This is the distinct difference between return on assets (ROA) and the asset turnover ratio, as return on assets looks at net income, or profit, relative to assets.
Use of Asset Turnover Ratio Formula
The higher the ratio, the more sales that a company is producing based on its assets. Thus, a higher ratio would be preferable to a lower one. However, different industries can not be
compared to one another as the assets required to perform business functions will vary. An example of this would be comparing an ecommerce store that requires little assets with a manufacturer who requires large manufacturing facilities and storage warehouses.
Another breakdown for the formula for asset turnover ratio is companies that are using their assets now for future sales. This may be more of an issue for companies that sale highly profitable products but not that often.
An example would be comparing two companies within a single industry where company A made 2 sales this year and company B made 1 sale, but expects to have a contract for 10 sales the following year due to spending a large amount in research and development this year on a new product. Of course, company A's expected sales next year is unknown, but it is possible that company B may still be a more profitable investment, assuming it maintains its short term solvency. This issue may apply, in general, to all companies, but the more that 1 sale makes a difference, the larger affect there will be on the formula for the asset turnover ratio.
Formulas related to Asset Turnover Ratio: Return on Assets (ROA)