Finance for Non-Financial Managers: Asset Turnover Analysis

Dave JonesBusiness Matters, Finance for Non-Financial Managers0 Comments

Asset Turnover

Finance for Non-Financial Managers: Asset Turnover Analysis

Asset turnover assesses how effectively a company uses the assets it has under its control. It does this by relating sales levels to the level of assets used to generate them:

Asset Turnover = Sales/Net Assets.

On a general basis, companies will aim to:

  • Maximise the level of total sales by setting the most effective marketing mix;
  • Minimise the level of net assets (in terms of the individual components that make it up).

From a managerial perspective, working capital is the element of Net Assets that can be controlled most effectively on a day-to-day basis.

The majority of working capital consists of three items from the Balance Sheet – inventory (stock), receivables (debtors ) and payables (creditors).

The level of each of these components is usually related to the volume of business a company is engaged in.

Working capital levels can be assessed by working out the value of the ratio of each element (e.g. inventory, receivables or payables) in relation to sales.

This is normally expressed in terms of a defined period of time (in days).

The inventory (holding) ratio can be formulated in one of two ways (driven by conventions within the industry in question, and/or the preferences of those conducting the analysis):
No. of days for which inventory is held; Frequency with which inventory is ‘turned over’.

Inventory days are calculated by dividing inventory by sales, and then multiplying the result by 365 (or 360 if you prefer
a round number).

Inventory days = (Inventory/Sales) x 365.

The inventory holding ratio strips out the effect of the level of sales in any particular year, making it easier to compare a company’s inventory holding over time.

In situations where analysts can access cost of sales data (or the value of inventory at selling price), the ratio can be further refined in its comparison of inventory to volume.

Please note:  an inventory ratio figure is a ‘snapshot’ of a particular point in time, and may be atypical when compared to other times of year for a business (for example, as seasonal factors may affect them).

Receivables days = (Receivables/Sales) x 365.

For most businesses, using the receivables ratio is preferable to the inventory ratio because both sales and receivables are valued in terms of the selling price. (However, this does not apply in cases where a large percentage of sales are made for cash).

Please note: As with using the inventory ratio, seasonal factors may undermine the representativeness of the receivables ratio value – as may the one-off impact of a large customer payment being made.

Payables days = (Payables/Sales) x 365.

The payables ratio has a similar limitation to the inventory ratio in that it does not give an absolute measure, as payables are not valued at selling price.

When used for internal purposes, it is preferable to utilise purchases instead of sales (and to isolate trade payables).

An alternative approach for assessing payables levels is to compare them to the level of inventory at the same point in time, expressing the result as a percentage: (Payables/Inventory) x 100

Fixed Asset Turnover

Fixed Asset Turnover

As well as being driven by working capital, the level of asset turnover is also determined by a company’s fixed assets.

In the long-term, the level of fixed assets within a company can be controlled by the managers of a business – so analysing levels of fixed asset investment compared to sales results in another key analysis ratio: Fixed Asset Turnover.

The ‘ratio’ version of Fixed Asset Turnover = Sales / Fixed Assets.

A business will want this to have a high value as the higher the value of the ratio is, the greater the level of sales that are being produced for the capital that has been invested in the business.

The ‘percentage’ version of Fixed Asset Turnover = Fixed Assets / Sales.

Management would want the value of this ratio to be low. The reason for this is that the lower the value of the ratio is, the less capital the business is needing to invest to produce a particular level of sales.

If a business wants to improve its fixed asset ratio by either reducing it in its ‘percentage’ form, or increasing it in its ‘ratio’ form, it has two options:

  1. Produce more sales for a given level of investment.
  2. Cut the level of fixed assets that the company needs in order to generate sales at a given level.

Over the long-term, depreciating fixed assets will cancel-out over the lifetime of the asset: it is merely an accounting device.

In terms of affecting profits for a single year, selling off fixed assets raises the risk of a divergence between book value and sale price for the asset concerned – which would hit the income statement (P&L)  for the year concerned.

Approaches for improving Fixed Asset Turnover must always be assessed to clarify whether they will increase costs. For example, additional sales may raise marketing expenses.

Such an increase could potentially cut profits – so here, analysing the potential impact by using the profit margin and ROCE ratios will help to clarify the net impact on the overall profitability of the business.

Improving asset turnover

Consider the following issues to utilise fixed assets more effectively:

  • Are capital projects authorised in a controlled manner, using cost benefit analysis?
  • Are they re-evaluated against projected volumes as these change?
  • Is a clear choice made re purchasing vs. hiring/leasing?
  • Is preventative maintenance used to prevent downtime?
  • Can assets that are not required be sold/traded?
  • Are assets replaced once they become unproductive?
  • Is surplus space rented out?

To ensure inventory is being managed as effectively as possible, consider the following:

  • Are all orders checked to assess whether inventories are being minimised?
  • Could consignment agreements be reached where inventory is paid for only when consumed/sold?
  • Are inventories reduced with production/sales volumes?
  • Could inventory types/lines be reduced?
  • Could production be better planned to reduce required inventory, spare parts etc (e.g. with Just-In-Time methods)?
  • Is it possible to identify (and eliminate) excess, obsolete or unsalable inventories?

In order to more effectively manage the receivables element of working capital:

  • Do processes exist to ensure all shipments are invoiced and credit notes are authorised?
  • Is it possible to reduce the credit terms on offer (e.g. through offering cash discounts?)
  • Is credit limited to slow payers?
  • Is it possible to fund staff expenses using credit cards?
  • Can collection be speeded-up (e.g. via charging penalties or through personal contacts?)
  • Can queries/outstanding matters be swiftly resolved to facilitate swift payment?
  • Are settlement terms offered to receivables prior to legal action?
  • Are miscellaneous receivables (e.g. staff loans) reviewed on a regular basis?
  • Can staff loans be financed in an alternative way?

In terms of managing payables:

  • Is credit taken on the best available terms?
  • Are goods received always checked to ensure they meet specification?
  • Are incentives such as cash discounts analysed in terms of cost benefit analysis?
  • Is it possible to delay payments for services such as insurance?
  • If overseas suppliers are engaged, are they applying for export finance – and passing on the benefits? Are arrangements in place to hedge any currency exposures?
  • Might it be possible to defer some benefits (e.g. bonuses) to year-end?
  • Are competitive quotes obtained from a range of suppliers?
  • Is it possible to change monthly payments to annual payments (in arrears?)

When it comes to leasing:

  • Could arrangements for leasing potentially finance sales?
  • What advantages could there be in entering into leasing contracts?
  • Can some book debts be sold (with or without recourse?

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