Yesterday, I wrote an article that discussed some of the various ratios that investors can use to assess a companyâs liquidity. To recap, liquidity is the ability to meet short-term financing needs. A company that is not able to do so risks falling into a so-called âliquidity trapâ which can lead to falling confidence among its customers and clients. Today, I want to look at another set of ratios that value investors should be using - those that measure operating performance.
Unlike the working capital management ratios we looked at yesterday, which measure how efficient a company is at managing its day-to-day cash flows, operating performance ratios are more concerned with a companyâs general use of assets. Operating performance ratios can be sorted into two broad categories: those concerned with efficiency and those concerned with profitability. For now, letâs concentrate on the former category.
Total asset turnover ratio
This ratio is calculated by taking sales for a period and dividing them by the average total assets of the business. This is a measure of how good the business is at using its assets to produce revenue. A high ratio indicates that a business is using its assets efficiently, while a lower ratio is a sign of inefficiency in this regard. However, an excessively high ratio is not necessarily a good thing - it could mean that the businessâs asset base is depreciating. You need to pay close attention to whether the numerator or denominator is responsible for any extreme results that you get.
As with many ratios, asset turnover is more useful as a relative, rather than absolute, measure. Some sectors are inherently capital-intensive and have a lot of assets - think manufacturing, energy and transportation. Companies in these industries will naturally have a much lower asset turnover ratio than those in the retail space, which have comparatively lighter asset bases and high sales.
Fixed asset turnover ratio
This is similar to the total asset turnover ratio, except that it only takes into account fixed assets. The reason for this is that the fixed asset turnover ratio allows the analyst to measure specifically how efficient the business is at utilising things like its property, machinery and equipment - the âtoolsâ that it needs to go about its business.
As such, it is sometimes considered to be a more accurate measure of company efficiency, particularly when it comes to capital-intensive businesses. On the other hand, it may not be an appropriate metric for a knowledge-intensive business like a consultancy firm with few fixed assets, as it can overstate how efficient such businesses are.
Note that while sales numbers can be found on the income statement, which covers a given period, assets are found on the balance sheet, which is a snapshot in time. This is why we use the âaverage total assetsâ - usually calculated as the average of the assets at the beginning and at the end of the relevant accounting period. We will use averages in almost all cases where a ratio calls for an income statement figure to be combined with a balance sheet figure.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Should Berkshire Hathaway Analyze the Moats of Technology Companies
- How to Measure a Company's Liquidity
- Howard Marks: Cycles Are Important, but Not Necessarily Regularââš
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