Efficiency is the ability of a business to perform effectively and utilize its assets to generate revenue, and is indicated in the financial projections template by the asset turnover ratio. The ratio is an indicator of how well a business can generate revenue (and therefore profits) from its asset base.
Asset Turnover Formula
Generally, the higher the asset turnover the more efficient the business is at generating revenue from its asset base.
As assets = debt (liabilities) + equity, the ratio also measures how efficient the business is at generating revenue from the total debt and equity funding used in the business.
Asset Turnover Ratio Example
The income statement and balance sheet below are used as an example to show how to calculate the asset turnover.
|Cost of sales||145|
|Income before tax||48|
|Income tax expense||12|
|Property, plant and equipment||130|
|Total liabilities and equity||205|
The numbers used in the calculation of the asset turnover ratio are highlighted in the income statement and balance sheet shown. In the above example the revenue is 246 and the assets are 205.
Using the asset turnover ratio formula the calculation is as follows:
Asset turnover ratio = Revenue / Assets Asset turnover ratio = 246 / 205 Asset turnover ratio = 1.2
In this case the ratio indicates that for each 1 invested in assets the business generates 1.2 in revenue.
Real Life Asset Turnover Examples
The asset turnover ratio will vary from industry to industry. Consequently it is important when making comparisons to determine an industry turnover ratio based on financial statements of businesses similar to your own.
To illustrate the difference in the asset turnover ratio from industry to industry, the following table sets out the calculation of the ratio based on the Apple income statement. and balance sheet, and the Amazon income statement and balance sheet.
Apple has a low asset turnover ratio and generates 0.83 in revenue for every 1 invested in assets, whereas Amazon has a higher asset turnover ratio and generates 1.85 for every 1 invested in assets. Generally, the lower the profit margin of the business the higher the asset turnover ratio.
The asset turnover ratio is reported on the ratios page of the financial projections template. The ratio should be monitored to ensure that it is consistent with the industry in which the business operates, and shows a value which is improving over time as the business becomes more efficient, and starts to grow revenue at a faster pace than its assets.
There is no correct value for the turnover ratio, care needs to be taken if the ratio becomes too high, as although it could indicate a very efficient business, it might indicate that the business is starting to over-trade; generating too much revenue with too little investment in assets.
Note on averaging balance sheet amounts
This ratio includes an income statement amount (revenue) which is for a period of time (usually a year), and a balance sheet amount (assets) which is given at a particular point in time (usually the year end). To avoid distortion of the ratio, if there are significant changes in the balance sheet amount over the accounting period an average of the beginning and ending balance sheet amounts can be used.
Asset turnover ratio = Revenue / Assets Asset turnover ratio = Revenue / (Beginning assets + Ending assets) / 2
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.