Effective asset management and efficiency is a key trait of successful companies.
But how do you know if a company is effectively managing its assets and receiving a high return on investing in those assets?
The answer is found by analyzing a company’s asset management ratios, or efficiency ratios, to determine whether that company is deploying and managing its resources effectively.
In today’s post we'll cover the basics of asset management ratios, what they measure, and why you should be analyzing these ratios to better understand a company’s operations.
We’ll also break down five key ratios that evaluate a company’s asset efficiency, and share a list of all asset management ratios, along with the formulas that you will need to calculate them.
What are Asset Management Ratios and What Do Asset Management Ratios Indicate?
These ratios measure how effectively and efficiently a company is managing its assets and producing sales.
Knowing a company’s asset management ratios will give you a better idea of how a company is managing its capital, and whether they are efficiently turning assets into earnings for the company’s shareholders.
Strong companies utilize their assets to create additional cash flow and revenue for their business to reinvest and redeploy back into operating activities. If a company has too much of their capital tied up in assets, this can lead to shortfalls in operating cash flow.
You may be wondering:
I thought assets were a good thing? Those assets have value and they’ll get money eventually, so what’s the big deal if it takes a while?
Well, the problem with this scenario is that if a company continues to manage their assets at a low level, they’ll be forced to raise additional capital, or take on additional debt just to meet the immediate cash flow demands of the company.
Let's say you are analyzing a company, and the first thing you look at is its current ratio and you notice that, dang, this company is on point! Highest current ratio you have ever seen.
And look at Accounts Receivable - it’s three times higher than you would have expected, nice!
Not so fast.
As a fundamental investor, you know the importance of getting the complete picture, so you force yourself to carry out your analysis and dive into the asset management ratios of the company.
Uh-oh, your view of the company starts changing.
Their accounts receivable turnover ratio is way lower than industry averages! They have inventory piled up on the balance sheet, and it doesn’t look like they’re selling it as fast as they’re producing!
Where’d it all go wrong?
The answer is, assets can be a key part of an awesome company, but if the management team isn’t effectively utilizing those assets, and turning those assets into operating cash flow, the shareholders won’t be seeing the returns!
Our goal is to find companies to invest in that are well positioned with adequate assets to maximize cash flows and returns to investors.
What we don’t want to see is a company that is stacking up assets and burning cash, but not turning those assets into cash flow quickly enough to enhance the company’s growth.
Analyzing these ratios is a key step in effective financial analysis and fundamental analysis.
Now that our understanding of the overall principle of asset management ratios is clear, we can start looking at the different types of ratios and their formulas.
5 Key Formulas for Measuring How Well a Company Manages Its Assets
There are five main ratios that measure how a efficiently and effectively a company is managing its assets and using its assets to grow operations.
We’ll start with taking a look at the accounts receivable turnover ratio.
The accounts receivable turnover ratio is calculated by taking a company’s net credit sales during a period, and dividing it by the company’s average accounts receivable.
A/R Turnover = Net Credit Sales / Average Accounts Receivable
The accounts receivable turnover ratio measures how effectively a company is extending credit and collecting amounts due from customers.
The higher a company’s accounts receivable turnover ratio, the more efficiently that company is extending credit and collecting cash.
To break it down, let’s say a company has amazing customers. They never haggle on credit terms, and they are never a day late in making payments.
Because of this, the company offers credit terms of 3 days, meaning a customer owes the company for services 3 days after the company bills the customer (this is very tight, generally when companies extend credit terms to customers they are about 30 days on average).
In this scenario, you would have a high A/R turnover ratio, because customers are consistently making purchases and paying the company very quickly.
A low A/R turnover ratio would indicate the company is extending longer terms (meaning the company isn’t collecting money quickly), or they are extending short terms to customers who aren’t paying their obligation by the due date.
Either way, not a good sign for the company!
As a quick example of the calculation:
Apple, Inc. (AAPL) reported accounts receivable of $17,874,000 and $15,754,000 as of September 30, 2017 and 2016, respectively. They also reported sales of $229,234,000 during 2017.
Apple’s AR turnover ratio for 2017 was the sales during the period, $229,234,000, divided by the average of the accounts receivable balance during the period (($17,874,000 + $15,754,000) / 2)).
As investors we want companies to be collecting cash for sales quickly so they can reinvest that money into ramping up growth.
The inventory turnover ratio is calculated by taking a company’s cost of goods sold during a period and dividing that amount by the average inventory during that period.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
The inventory turnover ratio measures how quickly a company is selling its inventory over a period of time.
If a company’s inventory turnover ratio is high, this would be an indicator that they are producing and selling inventory at a fast rate - which is good news for investors!
If the inventory turnover ratio is low, or slowing compared to the company’s historical turns, that could be an indicator that the company’s sales are slowing, or they aren’t managing their inventory levels effectively.
Evaluating a company’s inventory turnover ratio will give you a good idea of how a company is managing its inventory levels, and whether sales demand remains high for the company.
As investors, we are looking for companies that turn inventory quickly and efficiently.
3. Working Capital Turnover Ratio
Alright, we have arrived at our third key ratio, the working capital turnover ratio.
The working capital turnover ratio is calculated by dividing a company’s net annual sales by their average amount of working capital during the same 12 month period.
Working Capital Turnover Ratio = Net Annual Sales / Average Working Capital
Let’s take a look at how this would be calculated for Apple Inc over the 2017 period.
Apple’s working capital (current assets - current liabilities) was $27,831 and $27,863 for 2017 and 2016 (in millions), meaning an average working capital of $27,847.
Reported revenue was $229,234.
If we plug the reported numbers into the formula above, we end up with:
$229,234 / $27,847 = 8.23 Working Capital Turnover Ratio
The working capital turnover ratio measures how well a company utilizes its working capital to support their sales. A high working capital turnover ratio would indicate that the Company is able to fund its own operations, because cash is flowing in and out on a consistent basis.
Too high of a working capital turnover ratio could indicate that the company isn’t generating enough money to support its sales growth, which means they could become insolvent.
This is generally not a huge concern, but if you start seeing extremely high working capital turnover ratios, usually over 70%, it will be important to consider the potential implications of burning through working capital that quickly.
If a company’s working capital turnover ratio is low, this could indicate that there is a build up in key operating accounts (primarily, accounts receivable and inventory), which could indicate that they are carrying obsolete inventory, or aged receivables that will eventually be written-off.
4. Fixed Asset Turnover Ratio
The fixed asset turnover ratio is calculated by taking a company’s net sales during a period and dividing that by the company’s fixed assets (commonly referred to as property, plant and equipment (PP&E)), net of depreciation.
Fixed Asset Turnover Ratio = Net Sales / Fixed Assets, Net
The fixed asset turnover ratio measures the rate and efficiency that a company is generating net sales from its investments in PP&E.
If a company’s fixed asset turnover ratio is high, this is a good indicator that tells us the company is making smart investments in fixed assets, and those investments are paying off as they are generating net sales for the company.
Both positives in my book!
Generally, there isn’t a specific benchmark to use in your analysis that would tell you whether the ratio is high enough to warrant an investment.
For this reason, it is important to benchmark the calculated ratio against the company’s historical fixed asset turnover ratio (declining ratios could signal an issue), or benchmark the company’s calculated ratio against direct competitors.
The fixed asset requirement for a company to be successful is very different depending on the operations of a company.
An internet company would have a much different fixed asset requirement than a heavy machinery manufacturing company.
Comparing the internet company’s fixed asset turnover ratio to the heavy machinery manufacturing company wouldn’t provide much value.
In general, the more heavily a company relies on its fixed assets to operate, the more relevant the fixed asset ratio is to that company.
The asset turnover ratio is calculated by taking a company’s revenues during a period and dividing that by the company’s average total assets.
Asset Turnover Ratio = Revenues / Average Total Assets
The asset turnover ratio is similar to the fixed asset turnover ratio, as it measures the level of efficiency that a company is using its assets to generate sales, but it takes it one step further by including all assets, and not just PP&E.
If a company’s asset turnover ratio is high, this is a good indicator that the company is well positioned with revenue generating assets, and management is effectively managing those assets to generate sales.
It’s important to keep a few things in mind when analyzing a company’s asset turnover ratio:
- This ratio can fluctuate depending on the nature of the businesses operations and the industry the company operates in; and
- Because of this, finding the right benchmark to interpret the asset turnover ratio is very important.
For example, retail stores generally have higher asset turnover ratios, as the business doesn’t require a significant investment in assets to operate. On a very small scale, think about if you were to start a small boutique clothing shop.
All you would need was enough inventory to stock the shelves, you could then lease a store front, and away you go. The only significance asset required would be the inventory.
But think about this from an industry on the other end of the spectrum. Let’s say a telecommunications company.
Why you might ask?
Because telecommunication companies require a heavy asset load to operate and generate revenue. Think about the amount of equipment, cabling, hardware, etc… it takes for AT&T to build out their wireless network.
None of us could even think about starting a competitor of AT&T because of the investment it would require to build out the assets in order to operate.
Check out the example below:
|(in millions)||Wal-Mart Stores||AT&T Inc.|
|Average Total Assets||202,174||423,959|
|Asset Turnover Ratio||2.47||0.38|
As you can see, Wal-Mart’s asset turnover ratio is much higher than AT&T’s.
Does that mean that Wal-Mart is a better investment than AT&T?
It would require additional analysis and insight into how each company’s ratios are performing over time, and whether they have higher or lower ratios than their direct competitors.
In this example, the vastly different operations of AT&T and Wal-Mart make benchmarking one asset turnover ratio against the other very difficult.
For this reason, it's important to make sure that you're comparing financial ratios to similar competitors in order to get an accurate interpretation of the management team and operating results.
Complete Asset Management Ratios List and The Formulas You Need to Calculate Them
We’ve summarized the remaining asset management ratios below (including the ones we covered above), so you have a complete list of ratios and formulas to refer back to when you are knee deep in your fundamental analysis.
|Asset Turnover||Revenues / Average Total Assets|
|Inventory Turnover||Cost of Goods Sold / Average Inventory|
|Days Sales In Inventory||365 days / Inventory Turnover Ratio|
|Accounts Receivable Turnover||Net Credit Sales / Average Accounts Receivable|
|Accounts Payable Turnover||Total Purchases / Average Accounts Payable|
|Capacity Utilization||Actual Output / Potential Output x 100|
|Cash Conversion Cycle||Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding|
|Defensive Interval||Current Assets / Daily Operating Expenses|
|Fixed Asset Turnover||Sales Revenue / Total Fixed Assets, Net|
|Working Capital Turnover||Net Annual Sales / Average Working Capital|
These ratios will give you a good idea of whether a company is managing their resources efficiently.
Trends that indicate slowing turnover of the company's assets can be a warning sign that trouble may be heading down the pipeline.
The Power of Asset Management Ratios in Your Stock Analysis
Asset management ratios are a key piece of the overall fundamental analysis puzzle.
If a company's ratios indicate they aren’t managing their assets effectively and efficiently, that doesn’t bode well for the management team, or the company’s long-term growth potential.
When looking for stocks that provide a higher return and lower risk, we want to invest in companies that are converting assets to higher sales and generating operating cash flows to sustain the business.
Assets aren’t really assets if they aren’t managed correctly!
So, dig deep on a company’s asset management ratios before you invest to avoid surprises down the road.
If you're interested in finding stocks with optimal asset management ratios, check out our article that walks through the process of using a value stock screener to identify investment ideas.