Asset turnover is assessed by the asset turnover ratio to know whether the company is using its assets effectively in generating sales revenue. The question is, is your business effectively generating a worthy amount of revenue?
The formula for asset turnover ratio is:
Turnover ratio = Sales Revenues/Average Total Assets
Asset turnover ratio is equal to sales revenues over the average total assets. The higher the output, the lower amount of assets required to generate the same amount of revenue. The lower the number, the greater amount of assets required to generate the same amount of revenue. For example, if McDonald’s reports an asset turnover ratio of 2.48 for 2011 and the business competitor Burger King reports 2.75 for 2011, it means that McDonalds has been less effective in managing the use and level of its assets. McDonald’s requires more assets to produce the same amount of revenue as Burger King. Leverage, a general term in finance meaning any technique to multiply gains and losses, is increased or decreased depending on return of equity. Return on equity (ROE) measures a firm’s efficiency at generating profits from every shareholder’s equity. Firms can improve returns on equity by cheaper leverage, a higher turnover in sales, lower taxes, a cheaper leverage and a wider margin on sales.
Return on equity is defined by a formula as:
ROE = Net Income after tax/Shareholder equity
ROE, expressed as a percentage, is equal to a financial year’s net income over total equity and is best used to compare firms in the same industry. A common way to break down the ROE is by using a strategic profit model, the DuPont formula. ROE will equal net margin multiplied by asset turnover multiplied by financial leverage. Examples of a high ROE would be an increase in the net margin. Any increase in the profit margin brings in more money, which results to a higher over ROE. Similar to this, if the asset turnover increases, the firm yields mores asset sales, resulting in a higher ROE.
Last, an increase in financial leverage means that the firm is using more debt financing relative to equity financing – therefore a higher proportion of debt in the firm’s capital leads to a higher ROE. Take note that the advantage of financial leverage is diminished if the firm takes on too much debt, the cost of debt increases as creditors demand a higher risk premium, and thus ROE decreases.
The only way an increased debt will benefit a firm’s ROE is if the return on assets (ROE) of that debt exceeds the interest rate on the debt. Return on asset (ROA) is an indicator of how profitable a company is relative to its total assets and how efficient a management is at maximizing its assets to generate earning.
The formula for return on assets is:
ROA = net income/total assets
An efficient and beneficial asset turnover can be achieved with the right elements of good business. Firms with high profit margins tend to have a high asset turnover.
