The total assets turnover rate is really an all-encompassing blanket activity ratio. The other activity ratios have parameters and are more beneficial especially to businesses that depend heavily on its sales from that particular asset group. As an example, retail relies more on inventory than fixed assets. Some companies rely distinctly on unique assets for their sales. Here are some examples:
* Entertainment is almost entirely operated sourced from their copyrights to movies, music, games etc. to earn their income.
* Pharmaceuticals depend on research and development of new drugs and approval from the Food and Drug Administration; in effect, federal permission to sell their products.
* Communications is centered on owning a part of the frequency spectrum sold by the government. This sole ownership of the airwaves frequency allows them to charge fees from advertisers.
* Professional sports purchase talent with contracts from ball players. These potential stars generate ticket sales and marketing rights allowing the franchise to recoup their costs. These types of businesses rely essentially on intangible assets to generate revenue.
This chapter first defines the total assets turnover rate and the corresponding elements of the formula. The next section explains its overall value countered against its inherent limitations. The final section of this chapter explores how to best use this ratio in evaluating the fundamental business attributes of any company.
Total Assets Turnover Rate Formula
The formula is very similar to other activity ratios by comparing the net sales against total assets. As stated with the other activity ratios, most generic or introduction articles use total (gross) sales and not net sales. As a warning to the reader, use net sales with this formula. Compare the difference in the total sales against net sales for a simple sub shop whereby total assets equals $250,000. By the way, this is an example for a really small business.
Sales Section – Mom & Pop Sub Shop
Gross Sales $1,347,216 101.33%
– Discounts (Coupons) $14,743
– Returns 2,901
Sub-Total Discounts & Returns (17,644) (1.33%)
Net Sales $1,329,572 100.00%
Total Assets Turnover Rates
. Gross Sales Net Sales
Numerator = $1,347,216 $1,329,572
Denominator = $250,000 250,000
Ratio 5.38864:1 5.31829:1
Difference = .07035:1
The difference between the two values is discernible but not significant. However, magnify the impact with larger operations whereby greater leverage is exercised with total assets and the impact compounds in growth.
Now instead of one shop, suppose there are 10.
Because the learning curve (leverage) improves with each successive shop, total assets have decreased to $190,000 per shop ($1,900,000 in total). Now let’s look at the results (sales are a factor of 10):
The difference between the two really begins to magnify as the entity grows. Ten shops are still considered a small business.
Your penny stock companies will have 300 shops in the portfolio. You can imagine the impact this formula has with that volume of sales. Even more importantly is the adjustments value (returns and allowances) grow as a percentage of sales. Many businesses customarily exceed 5% as adjustments between gross and net sales. This greatly affects the formula’s results.
The funding of assets (capitalization) whether with loans or traditional equity often turns on this formula’s results. Loan agreements often mandate some turn ratio in order to ensure adequate cash flow to service the debt. Therefore it is imperative to get it right.
The next part of the formula, total assets, also greatly affects the results. Actually, this value has more bearing on the results than adjusted (net) sales. How so? Let’s take a look.
Assume sales of $10,000,000 with total assets of $700,000. The turn rate equals 14.286 to 1. Total assets is the denominator; let’s decrease total assets by 20% to $560,000. Using the same sales volume the adjusted turn rate equals 17.857 to 1. This is a 25% increase in the turn rate. If the total assets drop to $467,000 (a 33.33% decrease) the turn rate increases to 21.413:1 for a 49.9% increase. There is a non linear relationship between the change in assets and the change in the formula’s results. The formula merely identifies leverage of total assets to generate sales. In essence, the formula is designed to measure leverage.
Value and Limitations of the Total Assets Turnover Rate
To fully appreciate this ratio, the reader must understand the basic asset structure of most business operations. So let’s recall the basic and detailed organization of the assets section of the balance sheet.
Balance Sheet (Assets Only)
Current Assets $ZZZ,ZZZ
Fixed Assets (Net of Depreciation) ZZZ,ZZZ
Other Assets (Tangible & Intangible) ZZ ZZZ
Total Assets $Z,ZZZ,ZZZ
Note the three distinct groups of current, fixed and other.
– Cash $ZZ,ZZZ
– Inventory ZZZ,ZZZ
– Accounts Receivable ZZZ,ZZZ
– Prepaids Z,ZZZ
Sub-Total Current Assets $ZZZ,ZZZ
– Equipment $ZZZ,ZZZ
– Property ZZZ,ZZZ
– Structures/Improvements Z,ZZZ,ZZZ
– Technology ZZ,ZZZ
– Accumulated Depreciation (ZZZ,ZZZ)
Sub-Total Fixed Assets Z,ZZZ,ZZZ
– Land (Reserved) $ZZZ,ZZZ
– Art/Antiques ZZZ,ZZZ
– Other ZZ,ZZZ
Sub-Total Tangibles ZZZ,ZZZ
– Financial Costs ZZ,ZZZ
– Patents/Copyrights ZZZ,ZZZ
– Warranties ZZ,ZZZ
– Accumulated Amortization (ZZ,ZZZ)
Sub-Total Intangibles ZZZ,ZZZ
Sub-Total All Other Assets ZZZ,ZZZ
TOTAL ALL ASSETS $Z,ZZZ,ZZZ
Again the detailed format has three distinct groups just like the summary format. The other activity ratios focus in on either:
A) Fixed Assets Turnover, OR
B) Working Capital (Current Assets less Current Liabilities) Turnover.
The other asset groups are oddly ignored. However, the total assets turnover rate includes all three groups. As explained in the chapter, fixed assets turnover rate, the higher the turn rate, the more efficient management exercises the asset(s) to generate sales. Because fixed assets are a subset of total assets, its turnover rate will naturally be higher. It is simply the mathematical formula’s inherent results. As an example, fixed assets as a percentage of total of all assets is 65%. If net sales are $6,000,000 and total assets are $490,000, what are the respective ratios?
THE FIXED ASSETS TURNOVER RATE IS ALWAYS HIGHER THAN TOTAL ASSETS TURNOVER RATE.
This is why the total assets turnover rate is more generic and encompassing. Therefore its real value comes into play in two different ways.
First it acts as an indicator of improvement or change from prior periods. In effect, just as with other ratios, the reader compares several periods of values to determine if a trend exists. Naturally the desired trend is greater turns over prior periods. But this actually gets slightly convoluted as often what triggers significant sales improvements are changes in total assets position. As an example, suppose a marina installs a boat lift system capable of hauling out larger craft (30′ to 50′) at a cost of $1.2 Million. Sales increase $200,000 per year. In year 1, net sales are $2.3 Million with total assets of $1.3 Million. In year 2, the net sales increase $200,000 but the total assets increase significantly. Look at the turns ratio:
There is no doubt the turnover rate decreases and would indicate serious problems. However, in this industry the $200,000 increase in sales is directly attributable to the sales generated by the new lift system. If industry standards hold true, this lift system most likely generates cash flow of $120,000 to $130,000 per year. This is easily enough to service the debt principle of the loan involved. So in reality, even though there is a negative impact on this ratio from the increase in assets, it doesn’t mean the business is performing at a lower overall level.
Also, the reader must remember what business is about. The number one goal is profit. Profit is usually or desirably an improvement in the cash position. Therefore it is natural for the company to have continuously increasing assets. Therefore the ratio will tend to deteriorate towards lower values if all other factors remain the same.
Secondly, this ratio acts as a warning indicator or as a cheerleader in overall business performance. In general, anytime there is more than a 3% change in the ratio, whether up or down, then some kind of underlying group of assets change drove the overall change.
Remember, this is a general activity ratio. So for it to move 3%, one of the underlying groups of assets has a large change in value. To illustrate, lets break total assets into the three groups and calculate their respective activity ratios between two years. Only one group increases by 10%. Lets see the impact on the total assets turnover rate.
The total assets turnover rate decreased 4.19% which is more than 3% change. To achieve a 3% improvement based on sales given the change in fixed assets, sales will have to increase 7.5% ($277,700) in year 2. Therefore, assets have a greater bearing on the outcome with this formula. For a user of this ratio, he will want to know what drives this change. The comparison table points to the 9.1% decrease (from 10.57 to 9.61) in the current assets activity ratio. A simple 10% increase in current assets caused a 4.19% decrease in the total assets performance.
This illustration is why this particular ratio is valuable. Any change of 3% or more warrants further investigation into the source.
Most small businesses follow a typical pattern whereby in the early years assets grow rapidly in comparison to sales. So the total assets turnover rate tends downward when graphed. This stays true during the formative years of the entity. As maturity sets in, sales begin to blossom and assets remain relatively stable. Usually excess cash is used to reduce liabilities incurred early on to finance asset growth. Now the ratio will begin to trend higher as management utilize assets more efficiently.
During the first 10 years of a business this trend line resembles a check mark when graphed than a naturally increasing value line. Therefore, users of this ratio should almost ignore its value during the first five years of a business endeavor.
Another problem with this formula is the underlying numbers from the three distinct asset groups. As identified in the fixed assets turnover rate calculation, it is wiser to use historical cost basis than the depreciated basis for the denominator. This also applies to this formula. The total fixed assets should be increased by the total accumulated depreciation taken to date. All trend line values should incorporate this adjustment in their respective denominator.
This same principle is applied to amortized assets as well. Recall that other assets include tangible and intangible assets. Most intangible assets are amortized over their expected useful lives.
One last limitation to point out addresses unused or reserved (set aside) assets. It is not uncommon for businesses to spend excess capital on future assets. A good example is the purchase of land for future construction. This asset is posted to the other assets section (more than one year out for its use) within the tangible section. Often this value impacts the total assets balance by more than 5% thus affecting the ratio significantly. The ratio decreases yet the purchase or investment into this asset is a wise business maneuver.
So it is important for the user of this ratio to consider the distinct group changes when evaluating the results.
Proper Application of the Total Assets Turnover Rate
This particular ratio is so broad in scope that its application is truly limited. It should never be used in isolation for business investment purposes or to evaluate performance. The result merely indicates a relationship between net sales and the use of fixed assets to achieve those sales.
Its real advantage comes into play when comparing two periods of consecutive time. Anytime a difference of 3% occurs between the two periods, the user must investigate the underlying cause. Naturally, all owners want their business to grow which is customarily reported with increased sales, expanding equity (via retained earnings) and an increasing cash position as a result of collecting profits.
This particular formula can only compare two of these three elements.
Ideally as the business prospers and gains efficiencies the net profit margin will improve and if all other items remain normal, the cash position will increase. This means current assets will increase due to cash growth.
The user of this ratio should first investigate how the three distinct groups changed between the two periods. For illustration purposes, compare this flooring company’s asset changes between two years.
. York Floors Inc.
. Balance Sheet Assets Comparison
. Periods Ending December 31, 2015 and 2016
. 12/31/15 12/31/16
Current Assets $497,214 65.15% $531,919 64.03%
Fixed Assets (Gross) 203,940 26.72% 236,781 28.50%
Other Assets (Gross) 62,007 8.13% 62,007 7.46%
Total Assets $763,161 $830,707
Right away the reader can eliminate the other assets group for this analysis as there is no change in its asset values between the two years. The change in asset values occur with both fixed and current assets. Reading the notes to the financial statements reveals that the company purchased an extended van for use in the carpet division thus increasing fixed assets by $32,841. So on the face of the reports, nothing appears unusual and actually looks good. So let’s look at the total assets turnover ratios between the two periods.
. York Floors Inc.
. Total Assets Turnover Rates
. 12/31/15 12/31/16 Change
Net Sales $3,291,616 $3,602,003 9.43%
Total Assets $763,161 $830,707 8.85%
Turnover Ratio 4.313:1 4.336:1 .53%
In the overall scheme of things a one-half percent improvement doesn’t appear to be very good. The user will want to analyze and evaluate this change. So let’s start with some fundamental approaches.
Q: How long has this company been in business?
A: If the company were relatively young (less than 10 years) there should be significant growth or value changes with this ratio as with most ratios. However, with this company, it is 16 years old and so it is expected that with mature enterprises there will be less volatile improvements.
Q: Is there a significant variance in change between the two elements of the formula?
A: Look at the change in growth between the two elements. Both increased approximately the same in one year. If sales had jumped 20% to $4,000,000 the total assets turnover rate would have improved to 4.755:1 or a 10.25% improvement. Because both elements improved at the same rate (nearly the same rate), the 1:1 relationship dampened the overall change. In effect, the .53% improvement is merely the result of basic economies of scale. Had management been able to leverage assets this turnover rate would have improved at least 3%.
To illustrate, what if management was able to more efficiently operate the existing fleet and used any increase in current assets to reduce debt. In effect, no change would have occurred with total assets.
Q: What is the total assets turnover rate potential efficiency gain?
A: The efficiency gain is the best case scenario between the two years, essentially total assets remain the same, only sales increases. Let’s calculate the results.
. York Floors Inc.
. Efficiency Potential for Total Assets Turnover Rate
. 12/31/15 12/31/16 Change
Net Sales $3,291,616 $3,602,003 9.43%
Total Assets $763,161 $763,161
Ratio 4.313:1 4.720:1 9.43%
This means that had management been purely effective in operating existing assets between the two years, the entire total assets value at the end of 2016 could generate sales to end up with a 4.72:1 ratio. That is: sales could be as much as 4.72 times total assets of $830,707 (the new balance) or $3,902,937. This is an improvement potential of $300,934 over the actual outcome. If the company has a gross margin percentage of 40, the net profit before taxes could be as much as $120,375 higher. This is huge in a small business like this.
Q: Using 3% improvement, what is the expected sales for this company? 3% is considered a significant change.
A: Using $830,707 as the total assets at the end of 2016 and the ratio from the prior year of 4.313:1, stagnant (no real improvement) sales would be $830,707 times 4.313 which equals $3,582,839. A 3% improvement on this value equals $3,690,324. Here are the modified results:
. 12/31/15 12/31/16 Change
Net Sales $3,291,616 $3,690,324 12.11%
Total Assets $763,161 $830,707 8.85%
Ratio 4.313:1 4.442:1 3.00%
Management should expect a 3% improvement in overall performance from one year to the next and this ratio has the ability to measure that leveraging power. The other activity ratios identify the driver of this change.
One last note in regards to using this ratio. This ratio has little to no value with service based operations. Any service based business that generates more than 80% of its sales from labor should never use this formula in evaluating performance. The underlying asset in service is either physical labor or the knowledge/experience of its professional staff. Use alternative performance models such as the up-time formula to evaluate leverage. Service based operations that bill out to customers whereby 40 to 80 percent of the invoice is contingent on the labor component can use the total assets turnover ratio, but use it with caution.
Summary – Total Assets Turnover Rate
The total assets turnover rate is an activity ratio designed to evaluate the leveraging of all assets. The standard indicator of true increase is 3% or more with improvement related to consecutive periods. Readers should eliminate accumulated depreciation/amortization along with non-business performing assets (investments in securities, land purchased for future use, etc.) in establishing the denominator value.
In analyzing the results, separate the assets section into three distinct groups and identify the true driver of total assets change. Use variations of the formula including efficiency gains to determine true management performance. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.