Asset Utilization Ratios Measure How a Company Is Managing Its Assets

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Asset Utilization Ratios Measure How a Company Is Managing Its Assets

An asset is anything that a corporation owns. Corporate assets include cash, accounts receivable, inventories, prepaid expenses, property and equipment, and intangible assets such as copyrights and trademarks. A ratio that is used to determine how well a firm is managing its assets is called an activity ratio or asset utilization ratio. These ratios compare a company’s sales to different asset categories.

Investors use three ratios to measure performance: accounts receivable turnover, inventory turnover, and fixed asset turnover. Let’s look at them in more detail.

Accounts receivable turnover

Accounts receivable (A/R) reveal how much customers owe to the company. These are open accounts that have not yet been paid. Since accounts receivable are balance sheet assets, they reflect an investment by the company in those assets. Of course, the company’s goal is to collect customer payments and convert A/R into cash. The A/R turnover ratio measures how well accounts receivable assets are being managed. The formula for accounts receivable turnover is this:

Many companies have a large amount of their capital in the form of accounts receivable. Especially for these companies, it is important to have a consistently high accounts receivable turnover ratio. That means that, even though A/R might be high, sales are even higher. Such companies tend to have strong credit policies and solid relationships with their customers. This is a good sign for investors.

For example, suppose company XYZ has total sales of $500,000 and invests $100,000 into its accounts receivable. Its turnover ratio is therefore 500,000/100,000, or 5/1.

Inventory turnover

Every corporation needs to manage its assets well in order to create profits and maintain its operating margin. The inventory turnover ratio is used to determine how well a firm is managing its inventory. It reveals the number of times inventory is sold and replaced over a given year. Too much inventory can use up expensive capital and increase a company’s market risks. High inventory turnover generally indicates well-managed inventory management. The higher the ratio, the less time a product spends in inventory and the quicker it can make money. A falling inventory turnover ratio can be a warning sign for investors. It could mean that goods are starting to pile up on the company’s shelves.

To meaningfully evaluate a company’s inventory turnover ratio, it must be compared to that of others within the same industry, because industry averages for this ratio vary widely.

Here is the formula for the inventory turnover ratio:

If company XYZ has $500,000 in sales and $100,000 invested in inventory, its turnover ratio is 5.00. This indicates that the entire inventory of XYZ was sold and replaced about 5 times a year.

Fixed asset turnover

The amount of sales a company is generating from its investment in fixed assets—plants and equipment—is measured by the fixed asset turnover ratio. Fixed asset turnover gives investors an idea of how efficiently a company’s long-term assets are utilized. The more efficiently assets are utilized, the less they will have to be increased to raise sales. A high fixed asset turnover ratio indicates efficient management of company assets. A high ratio means a company can generate a high level of sales from its asset investments.

The formula for asset turnover is:

Imagine company XYZ has annual sales of $600,000 and fixed assets worth $300,000. Its fixed asset turnover ratio is 2. This means company XYZ has been generating $2 in sales for every $1 invested in plants and equipment.

In closing …

Investors can use asset utilization ratios to evaluate companies. The efficient management of company assets is an important economic indicator that can affect company profits and security prices. Understanding how to use these ratios gives investors a leg up on knowing which companies to invest in and which ones to avoid.