Asset Turnover Ratio And ROA

What Is The Difference Between Asset Turnover Ratio And ROA

Introduction

What is Asset Turnover Ratio

The ratio of a company’s sales or revenues to the value of its raw materials assets is known as the Asset Turnover Ratio.

It serves as a gauge on how well a business uses its resources to generate money. As a result, the Asset Turnover Ratio can be used to scale a business’s performance.

It is in terms of its ability to resources and how much value it can generate from them. The performance of the company improves as the ratio rises.

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Formula to calculate Asset Turnover Ratio

Asset Turnover Ratio = Total Sales / [(Initial Assets + Final Assets)/2]

A company’s average asset holdings at the start and end of a fiscal year can be used to compute the Asset Turnover Ratio.

It is calculated with the total amount of assets serving as the denominator. For businesses in some industries compared to others, the ratio may be larger.

What is ROA (Return On Asset)

Return on Assets depicts how much profit a corporation may make from its assets. To put it another way, Return on Assets (ROA) gauges how effectively a company’s management generates revenue from the assets or financial resources that appear on its balance sheet.

The greater the ROA, which is displayed as a percentage, the better a company’s management is at controlling its financial sheet to produce profits.

Formula to calculate ROA

ROA = Net Income / Total Value of the Asset

Difference Between Asset Turnover Ratio and ROA

Difference in calculating returns

The Asset Turnover Ratio is used to check the performance of the company in terms of the use of raw materials to produce finished goods.

Every company indeed needs raw materials to produce its final good. And the difference in the net income from selling the final goods to the difference in the cost of raw material used is the Asset Turnover Ratio.

On the other hand, Return on Asset (ROA) is used to check the total income generated from the overall asset owned by the company. This evidently includes fixed costs like the cost of machinery, other investments for building the business, etc.

The ratio of the net income to the total value of these assets is the ROA. The ROA tells the user how much money in the assets have gone to start/run the business.

Difference based on the types of assets used to compare

For calculating the Asset Turnover Ratio, assets pertaining to the raw materials and
other purchases that, subsequently, are used to prepare the final goods are used. These assets may or may not reflect in the balance sheet of a company.

While, for calculating the ROA fixed assets such as the cost of manufacturing plants, machines, and tools are used. These are all the assets that are displayed on the balance sheet of the company.

Difference in interpreting these financial figures

Higher the Asset Turnover Ratio, the better the outcome the company makes, therefore, from its raw materials assets.

An increasing asset turnover ratio depicts that the company is not only growing its annual sales but also optimizing its overall available assets.

On the other hand, companies with low ROA typically use more assets to generate their earnings. Businesses with a high ROA typically use fewer assets to produce their earnings.

A rising ROA moreover tends to indicate that a company is increasing its profits with each investment in the company’s total assets.

A declining ROA may consequently indicate that a company might have made poor capital investment decisions. And is therefore not generating enough profit to justify the cost of purchasing those assets.

A declining ROA could also indicate that the company’s profits are shrinking due to declining sales or revenue.

Difference between Asset Turnover Ratio and ROA with an example

Consider a bottle manufacturing company that has the following particulars:

  • A machine worth 10 lakhs. 
  • A plant worth 2 crores. 
  • Raw materials worth 50 lakhs at the start of the financial year and 15 lakhs at the end of the financial year. 
  • The company has made a net return of Rs. 6 crores in the financial year.

Thus,

Asset Turnover Ratio = Total Sales / [(Initial Assets + Final Assets)/2] = 6 Cr. / [(50 lakhs + 15 lakhs)/2] = 18.46

Total value of asset = Value of plant + value of machine = 2Cr. + 10 lakhs = 2.1 Cr.

ROA = Net Income / Total Value of the Asset = 6 Cr. / (2.1 Cr.) = 2.85

From the above example, we understand that the bottle company has a great Asset Turnover Ratio which means it can convert its raw material assets to a high-value product.

The Return on Assets of 2.85 depicts that the company uses a large number of assets to keep the bottle business running.

Conclusion

Essential indicators for assessing a company’s profitability are Asset Turnover Ratio
and ROA. They display the net income of a company in proportion to their respective assets.

Please Note: When comparing various companies, investors should remember that this is not the only important metric to consider.

Also Read: How Do Banks Make Money On Zero Interest Loan

The Intelligent Investor

The Intelligent Investor is a book by Benjamin Graham who talks about the concept of value investing.

As quoted by Warren Buffett “The Intelligent Investor is by far the best book on investing ever written”

Read: Why Warren Buffett Love Chapter 8 And 20 Of The Intelligent Investor

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