Asset Turnover - Analyzing an Income Statement

Investing Lesson 4 - Analyzing an Income Statement

Asset Turnover Calculation from the Balance Sheet
Asset turnover is a financial ratio calculated from the income statement and balance sheet that helps you figure out how efficiently a business is using the resources it has on the books. Alberto Incrocci / The Image Bank / Getty Images

Calculating Asset Turnover

The asset turnover ratio calculates the total revenue for every dollar of assets a company owns. To calculate asset turnover, take the total revenue and divide it by the average assets for the period studied. (Note: you should know how to do this. In lesson 3 we took the average inventory and receivables for certain equations. The process is the same. Take the beginning assets and average them with the ending assets.

If XYZ had $1 in assets in 2000 and $10 in assets in 2001, the average asset value for the period is $5 because $1+$10 divided by 2 = $5.) A quick exercise would benefit your understanding.

Asset Turnover = Total Revenue ÷ Average Assets for Period

In 2001 and 2000, Alcoa (Aluminum Company of America) had $28,355,000,000 and $31,691,000,000 in assets respectively, meaning there were average assets of $30,023,000,000 ($28.355 billion + $31.691 billion divided by 2 = $30.023 billion). In 2001, the company generated revenue of $22,859,000,000. When applied to the asset turnover formula, we find that Alcoa had a turn rate of .76138. That tells you that for every $1 in assets Alcoa owned during 2001, it sold $.76 worth of goods and services.

$22,859,000,000 revenue ÷ $30,023,000,000 average assets for period = .76138, or $0.76 for every $1 in revenue

General Rules for Calculating Asset Turnover

There are several general rules that should be kept in mind when calculating asset turnover.

First, asset turnover is meant to measure a company's efficiency in using its assets. The higher the number, the better, although investors must be sure compare a business to its industry. It is a fallacy to compare completely unrelated businesses as different industries have different customs, economics, characteristics, market forces, and needs.

The turnover for a local corner grocery store is going to be magnitudes quicker than the turnover for a manufacturer of space engine components or heavy construction equipment.

Second, the higher a company's asset turnover, the lower its profit margins tend to be (and visa versa). This is because many businesses adopt a low-margin, high-volume approach that can result in rapid growth and economies of scale. As we've previously discussed in many other articles, Wal-Mart is the quintessential example of this tactic.

Third, there may be special situations in which management purposely lowers asset turnover because it believes that a company's products are undervalued or there are other factors at play in the market that lead executives to think selling is disadvantageous at the time so they honor past sales contracts while stockpiling incoming production. A silver mine suffering from depressed silver prices may decide not to pre-sell so much of its output, instead locking it away in a vault and then turning around to halt production if the extraction cost exceeds the sale value of each Troy ounce. This does not indicate that management is doing something wrong, though it would create a blip on the financial statements.

In the long-run, the discipline they are showing may very well result in a lot more wealth being put in the owners' collective pockets. This is one of the big reasons you cannot just look at the asset turnover ratio trajectory and come to any hard and fast conclusions; you must understand the reason behind the direction it is going and whether or not you believe it to be justifiable by the facts and conditions in place at the time.

                                          Alcoa Financial Statement Excerpts

2001 Income Statement Excerpt
Period EndingDec 31, 2001Dec 31, 2000Dec 31, 1999
Total Revenue$22,859,000,000$23,090,000,000$16,447,000,000
Cost of Revenue$17,857,000,000,000$17,342,000,000$12,536,000,000
Gross Profit$5,002,000,000$5,748,000,000$3,911,000,000
2001 Balance Sheet Excerpt
Period EndingDec 31, 2001Dec 31, 2000Dec 31, 1999
Long Term Assets   
Long Term Investments$1,428,000,000$1,072,000,000$673,000,000
Property, Plant and Equipment$11,982,000,000$14,323,000,000$9,133,000,000
Intangible Assets$674,000,000$821,000,000$117,000,000
Accumulated AmortizationN/AN/AN/A
Other AssetsN/AN/AN/A
Deferred Long Term Asset Charges$1,746,000,000$1,894,000,000$1,015,000,000
Total Assets$28,355,000,000$31,691,000,000$17,066,000,000