Asset Ratios

Asset ratios measure the efficiency by which a company is using its assets (these include fixed assets, inventory and receivables). These ratios are generally applied by management to analyze the company’s performance over multiple periods. They serve as benchmarks or as warning signals on operational issues. Some of the most commonly used asset utilization ratios are described in the following section.

 

Total Assets Turnover

 

Total assets turnover ratio measures the efficiency with which the total assets are utilized in the business to generate revenue. It is calculated as:

 

Total Assets Turnover = Net Sales/ Total Assets

 

An increasing total assets turnover ratio indicates that the firm is increasing the productivity of its assets. For example, if the turnover for 2004 was 2.2×, and for 2005 is 3×, it would mean that the firm generated $3 in sales for each dollar of assets, an additional 80 cents in sales per dollar of asset investment over the previous year. These changes can be an indication of increased managerial effectiveness.

 

Fixed Assets Turnover

 

Similar to the Total Assets Turnover ratio, this ratio measures the efficiency with which the fixed assets of a company are employed .i.e., how well the fixed assets are utilized to generate revenue. In other words, it measures sales per dollar of investment in fixed assets. Analysts prefer this measure of effectiveness since fixed assets are more closely related to the production process than current assets like cash and accounts receivables. It is calculated as:

 

Fixed Assets Turnover = Net Sales/ Net Fixed Assets

 

A Fixed Assets Turnover of 1.6× indicates that the firm generated $1.60 in sales from every $1 invested in fixed assets. A large ratio generally indicates a high degree of efficiency in asset utilization and a small ratio reflects inefficient use of assets. However, in interpreting this ratio, it is important to keep in mind that when the fixed assets of the firm are old and substantially depreciated, the fixed asset turnover ratio tends to be high because the denominator of the ratio is very low.

 

Receivable Turnover

 

This ratio is generally used by banks and creditors. Receivables are current assets which are expected to be converted into cash during the next business cycle. Receivable turnover ratio measures the effectiveness of company’s receivable collection policy. It other words, it indicates how many times the receivables are converted into cash in a given period of time, usually a year. It is calculated as:

 

Accounts Receivable Turnover (in days) = Accounts Receivable / *Daily Credit Sales

*Daily Credit Sales = Net Credit Sales per year / 365 per year

 

Credit sales are a way of selling products on credit basis on with certain terms attached. Credit terms include credit period, discount allowed if cash is paid before due date and interest charged if credit is not paid before time. Similarly, companies make purchases on a credit basis, which are included as accounts payable on the Balance Sheet. It is generally assumed that a company will pay off their accounts payable with their accounts receivable.

 

Low receivable turnover rates may indicate that the receivables are not being collected reasonably in accordance with the credit terms. The company may face severe liquidity issues if its receivables are excessively slow in being converted into cash. Directly related to the receivable turnover is the average collection period which represents the number of days that credit sales are locked in accounts receivables. It is calculated as:

 

Average collection period = Receivables / Average daily credit sales

 

The average collection period should be compared to the company’s credit terms to judge the efficiency of its credit management. If the average collection period is longer than the credit period allowed by the company, it indicates weak collection efforts on the part of the company. However, an average collection period which is shorter than the credit period allowed by the company is not always a good sign. It may also indicate excessive conservatism in credit granting that may result in the loss of sales.

 

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