One way to measure the success of a company is to look at how efficiently it uses its assets to generate revenue. Asset turnover provides insight into the efficiency question and is defined as the ratio of the company's sales to its assets. In general, the more revenue a company produces from its assets, the more likely it is that the company will be successful. However, in comparing asset turnover across different companies, it's important to understand that different industries don't always have the same business models and can therefore require greater or lesser use of assets to drive sales.
The math of asset turnover
Mathematically, calculating asset turnover is simple. But there are some nuances that different analysts use in assessing companies. For example, some investors focus on the ending asset value in measuring asset turnover, while others take the average assets during the period by splitting the difference between the beginning-date value and the ending-date value. This can have a marked difference if a company makes a major acquisition or divestiture during the measuring period.
In addition, some related measures look at just a portion of a company's assets. The fixed asset turnover ratio is one example. It uses only fixed assets from the balance sheet, focusing on property, plants, and equipment and ignoring intangibles and other types of assets.
Why some industries have higher asset turnover than others
When you compare companies within an industry, it's generally fair to conclude that the one with the higher asset turnover is doing a better job in maximizing its sales opportunities. However, you'll often find that industries in which profit margins are relatively low tend to have higher asset turnover overall than industries where profit margins are higher.
The reason for this tendency is that in order to compensate for low profit margins, companies have to turn over their assets as quickly as possible. The retail industry is notorious for having low margins, and it's essential for retailers to move inventory through stores to keep offerings fresh and customers interested. By contrast, if profit margins are higher, the need to push sales in order to generate profit growth isn't as strong.
Also, some industries simply require more capital than others. The utility and telecom industry are examples of asset-rich businesses, because companies have to invest heavily in infrastructure and other fixed assets to provide their services. Regulated utilities count on earning back their capital expenditures slowly over time by passing through costs in the form of higher rates to customers.
Looking at asset turnover is a great way to measure how well a company is doing compared to its peers in driving sales from its asset base. As long as you know the potential pitfalls of the metric, asset turnover can tell you a lot about the future success of a company.
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