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The asset turnover ratio is a metric that is designed to measure the quantum of the revenue made by a company in relation to its total assets. It's calculated by taking the total sales and dividing it by the amount of assets. The value of assets can either be the closing value as disclosed every year or the average calculated by using the opening and closing values. More sophisticated investors could also consider using a time-weighted average if there are substantial variations in a company's asset base during the relevant period.
Given that capital is scarce, investors need a quick and easy-to-use ratio to understand how efficiently a company uses its capital. The asset turnover ratio fulfils one aspect of this need by giving a number that can be used to perform either a historical analysis of a company or a cross-sectional analysis of different companies in a sector.
One limitation is the difficulty in applying this metric to companies operating in different industries. For instance, it wouldn't be very meaningful to compare companies in the oil-exploration space with those operating in the retail industry, as they would have vastly different business structures. Also, by focusing on sales, the metric doesn't differentiate between businesses with different profit margins.
Case in point: Kalyan Jewellers
Among gold jewellers, Kalyan Jewellers has an asset turnover ratio of 1.01 times, whereas Titan, an established player with a diversified portfolio, has a ratio of 1.46. Therefore, investors can recognise that Titan can generate 45 per cent more sales than Kalyan Jewellers and hence, is a more efficient business.
Also in the series:
Look at the EPS, not just profits
What is the cash conversion cycle? Why does it matter?
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