The Sales to Total Assets Ratio: Turnover a New Life

Introduction:?Theory of Large Numbers

What happens when you take two large numbers and compare them over and over and over??Well, the Italian mathematician Gerolamo Cardano (1501–1576) stated postulated that the accuracies of empirical statistics tend to improve with the number of trials, and this was then formalized as a law of large numbers (LLN).Years later in 1713, Jacob Bernoulli was able to prove it[i] ?The law of large numbers is simply states that, as the number of trials or experiments increases, the average of the results of those experiments will converge to the expected value.

So, what if you take the two largest numbers in financial statements, sales and total assets, and compare them over and over??What does it mean, anyway?

The Sales/Assets Ratio in Perspective

The sales to total assets ratio measures the ability of a business to generate sales on as small a base of assets as possible. A high ratio implies that management is able to wring the most possible use out of a small investment in assets.[ii] ?The formula for sales to total assets is to divide net annual sales by the aggregate amount of all assets.?For example, Devco Corporation has generated $1,000,000 of revenues on total assets of $500,000 in its fiscal year 2022, so its FY 2022 Sales/Total Assets ratio is 2.00x:

$1,000,000 in Revenues ÷ $500,000 in Total Assets

Variations on the formula include refining both numbers but using net revenues and average total assets:

a)?????Revenues – returns and allowances = net revenues: $1,000,000- $50,000 in R&A = $950,000

b)????TA in 2022 = $500M, TA in 2021 = $400M, so average TA = ($500M + $400M)/2 = $450M

c)?????Net revenues/average TA = $950,000/$450,000 = 2.11x

The Financial Accounting Standards Board promulgated a new principle on revenue recognition effective after December 15, 2017, among other things, that should eventually restore the disclosure of returns and allowances to income statements,[iii] many sites that calculate the sales/assets ratio simply rely on total sales and total assets because gross revenues are usually more readily available.?For similar reasons, previous fiscal year assets are not always available, either so these sites use what they have.

Options for Raising the Sales/Total Assets Ratio (STAR):?More Sales, Fewer Assets?

As mentioned earlier, STAR is a productivity measure, how many dollars of sales can be generated by a dollar of assets, so the higher the result, the more productive the firm.?On the other hand, if a company’s industry has an asset turnover of, say, 2.0x, and the company’s ratio is 0.9; then the company is not doing as well as other firms in its industry. In this case, its lower asset turnover ratio may mean that the company is not using its assets efficiently to generate sales. Generally, a low asset turnover ratio suggests that the company has problems with surplus production capacity, poor inventory management, or bad revenue collection methods. [iv] ?

A firm can improve its STAR by increasing its sales relative to its assets or reducing its assets relative to sales.?Boosting sales often requires additional assets to support revenue growth, more inventory, more machinery, etc.?Moreover, the ability to generate sales does not necessarily translate into the ability to generate profits or cash flows. A company with a very high sales to total assets ratio could still lose money.?However, management might shut down its production assets and simply outsource production to improve this ratio yet upset the fundamentals of the business in several ways:[v]

1-They don't know your business

A good third party will do its best with the resources you give them to learn your company’s goals, brand, and style, but they won’t understand your business as an employee does.

2-Communication challenges

You might never meet the people you are outsourcing work to because it is not unusual to conduct business entirely online or over the phone/video. While today’s digital workplace makes this increasingly easy, you could find yourself playing phone tag, keeping up with different time zones, or having trouble communicating over email.

3-Difficulty with quality control

When you outsource, you typically give a vendor a statement of work, sign a contract, and wait for a finished product. If you are less involved, you might not be able to correct defects in the finished product before it is shipped to customers.

4-Tough on team morale

Outsourcing can lower morale if people think tasks are outsourced because they lack a skill set, or they might get nervous that you will outsource more and more work until their job becomes obsolete. If you do outsource, make sure you communicate the reasoning and goals behind outsourcing. For example, “We’re outsourcing initial outreach to give our existing sales team more time to close higher-value deals.”

5-Slow response time

You might not be the only client a vendor has. Unlike an employee, you cannot always tell a contractor to prioritize your products. While you ought to be respectful of their time, you must be assertive if the vendor is not meeting your agreed-upon timeline.

There are ways to control vendors when you outsource. For example, you and your team can develop a media or vendor kit of crucial information about your business, mission, and branding elements, tone, logo, color scheme, etc., that you can share to ensure finished products align with your needs.?You can also create a process where you have periodic check-ins to see how things are going and offer suggestions or ask for adjustments before it is too late. Not all vendors have this process, but if you are worried about being less involved, you should seek out vendors who allow it.

Because operating leases used to be off the balance sheet, leasing was another way to boost the STAR, but FASB’s lease capitalization principle now requires all leases over a year in length to be capitalized, adding a lease liability to the liabilities and a right-of-use (ROU) asset to total assets.[vi] ?Lease capitalization is likely to lower the STAR by adding ROU assets to total assets.

Further, when sales are cyclical, the sales level may spike and drop over time, irrespective of the size of the asset investment.?Therefore, recession is likely to reduce STAR, but even recovery and expansion may not improve STAR as much as hoped simply because as new plant and equipment are added to support sales growth, these new facilities are not likely to be 100% utilized.

Industry Averages:?Double Your Money?

Table 1 below reflects the differences in this ratio from industry to industry,[vii] and industries with lower investments in fixed assets and higher investment in faster-turning current assets tend to have better sales/assets ratios:

Table 1:?Asset Turnover Ratios for Various Industry Sectors as of Second Quarter 2023

Rank Industry Sector Ratio (x)* Examples of Industry Sector Contents

1 Retail 1.91 Apparel, big-box outlets, department store

2 Energy 1.02 Oil & gas, coal, renewable energy

3 Consumer Discretionary 0.84 Consumer durables, e.g., autos, appliances

4 Capital Goods 0.83 Aerospace, construction, machinery

5 Consumer Non-Cyclical 0.80 Consumer non-durables, e.g., food, beverages

6 Transportation 0.78 Railroads, shipping, airlines

7 Basic Materials 0.75 Chemicals, aluminum, containers

8 Healthcare 0.50 Healthcare facilities, pharmaceuticals

9 Conglomerates 0.49 Firms with multiple offerings across industries

10 Services 0.44 Professional services, entertainment

11 Utilities 0.33 Electric, natural gas, water

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*Trailing 12 months (TTM) calculated by dividing net sales by total assets

This data is drawn from publicly traded companies, which are scrutinized closely by market analysts, investors, and competitors.?These companies are likely to be very motivated to be as productive as possible, so the first inference is that this ratio tends to max out at around 2.0x, so borrowers claiming ratios above 2.0x should be asked to prove that they can operate at that high a level, especially if their asset mix is heavily fixed and their working capital assets turn over slowly.

Summary and Closing:?The Sales-to-Total Assets Ratio Is a Productive Way to Measure Performance

?Mark Twain advised: “Continuous improvement is better than delayed perfection,” and steadily boosting the amount of sales generated by all its assets is a sound way to improve a firm’s performance.?The sales/total assets ratio has been around for some time, and some recent industry statistics suggest that a ratio of 2.0x is probably as good as it gets.?Fortunately, the theory of large numbers suggests this ratio comparing the two biggest numbers in the firm’s financials is not going to bounce around very much, so it also offers a sound base on which to measure a firm’s productivity.?Do your own research to check out the evolution of this ratio as has been noted here. As comedian Steven Wright explained: “To steal ideas from one person is plagiarism; to steal from many is research.”?Stop stealing, start researching!

[i] “Law of Large Numbers,” Wikipedia, https://en.wikipedia.org/wiki/Law_of_large_numbers#:~:text=The%20Italian%20mathematician%20Gerolamo%20Cardano,first%20proved%20by%20Jacob%20Bernoulli .

[ii] “Sales to Total Assets Ratio Definition,” Accounting Tools.com, July 26, 2023,?https://www.accountingtools.com/articles/sales-to-total-assets-ratio.html

[iii] “Revenue Recognition,” https://fasb.org/page/PageContent?pageId=/projects/recentlycompleted/revenue-recognition-summary.html

[iv] ?Obutu Agape Oguche, “Asset Turnover Ratio Interpretation and Examples,” Financial Falconet.com, November 30, 2022, https://www.financialfalconet.com/asset-turnover-ratio-interpretation-and-examples/

[v] ?Meg Prater, “Outsourcing: Pros, Cons, & Projects to Consider When Hiring a Third Party,” May 9, 2023,?https://blog.hubspot.com/sales/outsourcing

[vi] See https://fasb.org ??for more information on ASC 842 Lease Capitalization

[vii] “Asset Turnover Ratio Screening as of Q2 of 2023,”?https://csimarket.com/Industry/Industry_Data.php