What It Measures
How efficiently an organization uses its resources and, in turn, the effectiveness of the organization’s managers.
Why It Is Important
The success of any enterprise is tied to its ability to manage and leverage its assets. Hefty sales and profits can hide any number of inefficiencies. By examining several relationships between sales and assets, asset utilization delivers a reasonably detailed picture of how well a company is being managed and led—certainly enough to call attention both to sources of trouble and to role-model operations.
Moreover, since all the figures used in this analysis are taken from a company’s balance sheet or profit and loss statement, the ratios that result can be used to compare a company’s performance with individual competitors and with industries as a whole.
Many companies use this measure not only to evaluate their aggregate success but also to determine compensation for managers.
How It Works in Practice
Asset utilization relies on a family of asset utilization ratios, also called activity ratios. The individual ratios in the family can vary, depending on the practitioner. They include measures that also stand alone, such as accounts receivable turnover and asset turnover. The most commonly used sets of asset utilization ratios include these and the following measures.
Average collection period is also known as days sales outstanding. It links accounts receivable with daily sales and is expressed in number of days; the lower the number, the better the performance. Its formula is:
Average collection period = Accounts receivable ÷ Average daily sales
For example, if accounts receivable are $280,000 and average daily sales are $7,000, then:
280,000 ÷ 7,000 = 40 days
Inventory turnover compares the cost of goods sold (COGS) with inventory; for this measure, expressed in “turns,” the higher the number the better. Its formula is:
Inventory turnover = Cost of goods sold ÷ Inventory
For example, if COGS is $2 million and inventory at the end of the period is $500,000, then:
2,000,000 ÷ 500,000 = 4
Some asset utilization repertoires include ratios like debtor days, while others study the relationships listed below.
Depreciation/Assets measures the percentage of assets being depreciated to gauge how quickly product plants are aging and assets are being consumed.
Depreciation/Sales measures the percentage of sales that is tied up covering the wear and tear of the physical plant.
In either instance, a high percentage could be cause for concern.
Income/Plant measures how effectively a company uses its investment in fixed assets to generate net income.
In these two instances, high numbers are desirable.
Plant/Assets expresses the percentage of total assets that is tied up in land, buildings, and equipment.
By themselves, of course, the individual numbers are meaningless. Their value lies in how they compare with the corresponding numbers of competitors and with industry averages. A company with an inventory turnover of 4 in an industry whose average is 7, for example, surely has room for improvement, because the comparison indicates that it is generating fewer sales per unit of inventory and is therefore less efficient than its competitors.
Tricks of the Trade
Asset utilization is particularly useful to companies considering expansion or capital investment: if production can be increased by improving the efficiency of existing resources, there is no need to spend the sums expansion would cost.
Like all families of ratios, no single number or comparison is necessarily cause for alarm or rejoicing. Asset utilization proves most beneficial over an extended period of time.
Studying all measures at once can devour a lot of time, although computers have trimmed hours into seconds. Managements in smaller organizations may conduct asset utilization on a continuing basis, tracking particular measures monthly to stay abreast of operating trends.