What is the Asset Turnover ratio and why is it important in a business plan for a Electrical Contractor?

The Asset Turnover ratio is a key profitability ratio for a small business like Lights On Electrical, Inc.. It measures the ability of a small business like Lights On Electrical, Inc. to generate enough sales to cover its assets. In other words, it is a measure to get a sense of how many times the total assets of the firm are being covered by the Sales / Revenues that the small business brings in. Clearly the higher the Asset Turnover ratio the better it is for the company.

It is important for a small business owner like Andy Powell to understand that the Asset Turnover ratio is best used to compare the condition of the business from time to time and also to compare the health of the small business to other businesses. It is a key profitability ratio that is looked at by lenders and potential partners who may be looking to lend or invest into the small business.

How about businesses and industries with a low total asset base - how should they be analyzed?

It is important to understand that small businesses that have a lower total asset investment will always have a higher Asset Turnover ratio when compared to those small businesses that have a higher fixed asset investment requirement. Thus comparing the Asset turnover ratio of a restaurant to that of a mortgage broker will not make much sense unless you are looking to find businesses with a low fixed asset component to invest in. A restaurant requires a higher fixed asset investment in furniture, equipment and infrastructure, where as a mortgage broker office requires a relatively smaller investment in office equipment to get the ball rolling. Thus when looking at the Asset turnover ratio of each of these businesses, you will certainly find that for the same $100 in sales, the asset turnover for restaurant will be lower than that of the mortgage broker.

Does a declining Asset Turnover ratio for a small business like Lights On Electrical, Inc. indicate that it is in trouble?

It could. A declining Asset Turnover ratio for a small business like Lights On Electrical, Inc. indicates that either the sales for the business are slowing down and / or the total fixed asset base has increased. In the case the sales of Lights On Electrical, Inc. indicate a slowing pattern, a small business owner like Andy Powell will have to take corrective measures and try and understand why sales are slowing down. The business owner could resort to a number of things to remedy the slower sales such as offer more incentives and discounts or revisit the pricing policies of the business. It is quite possible that the slow down in sales is due to the a recent change in the pricing policy and the small business may have to revert back to the older policy to regain sales momentum.

On the other hand if further analysis of the declining Asset Turnover ratio shows that the sales are constant but there has been an increase in the total assets for a small business like Lights On Electrical, Inc. then it could well be because the small business has recently made a larger investment in a fixed asset and hence the Asset turnover is lower. Thus for example if a dental office were to go out and buy a new panoramic x-ray machine to replace the older one it would show an increase in the Total Asset value of the business and result in a lower Asset Turnover ratio.

In those situations where the Asset Turnover ratio is declining due to an increase in the Total Assets, a small business owner like Andy Powell may have to consider if the business has been aggressive enough in raising prices to be able to cover the new assets that have been deployed. Of course being competitive is also very important and as always a balance has to be struck between the price increase and the possible loss of a competitive position. A new laser being purchased at a Dental Office which gives the office an unique edge over its competitors must be met with a special fee or higher prices charged by the firm to be able to cover the higher total fixed asset investment.

Does having a higher Asset Turnover ratio improve the competitiveness of a small business like Lights On Electrical, Inc.?

Yes. If a small business like Lights On Electrical, Inc. has a higher Asset Turnover Ratio than its competitors, it means that is generating more sales dollars to cover its Total Asset investment than the competition. This is a very important competitive advantage since Lights On Electrical, Inc. will be able to cover its investment in the Total Assets much quicker than the competition and will be able to upgrade its asset base quicker than the others as well giving it yet more competitive advantage over its peers. The example of the dental office laser is very appropriate.

Having a high Asset Turnover ratio is also important in industries where the fixed asset investment is very high. Thus small businesses which require a lot of up front investment like franchises and restaurants need to be able to generate a good dollar amount in sales to be able to offset the higher investment in Total Assets required by the franchise or the nature of the business.

Quick Links:

1. Go to the Corresponding Template section for this industry.
2. Go to the Corresponding Business Plan section for this industry.