The asset turnover is a ratio and we use it to tell how good a company is at generating sales revenue given the number of assets that the company has. So we calculate the asset turnover ratio by taking the company's net sales revenue and dividing it by the company's average total assets. You would get the average total assets from the prior two years of balance sheets.
Let me show you an example with a couple of firms and I'll show you how to calculate the asset turnover ratio and then how to interpret it. So let's say that the two companies we have, where one of them has a much higher profit margin but they both have the same ROA (Return on Asset). It's not always gonna be that way in real life I'm just giving you this as an example to kind of show why the asset turnover ratio is important.
So let's say we've got Mobis Groceries they had $100,000 in net income and then Luxury Clothing for Cats they also had $100,000 in net income and but Mobis had $5,000,000 in sales Luxury Clothing for Cats have $1,000,000 in sales and then we've got the average total assets that I've calculated 2million for each company.
So the ROA for each of these companies the return on assets would be 5% and again the ROA is just the net income divided by average total assets. So for each company, it's $100,000 divided by 2million which gives you 0.05 but you multiply it by 100 and add a percent symbol, so they each have the same ROA.
So then we look at the profit margin, which is the net income divided by net sales and we'll show you that in another article so I won't go through it here too much but we take for Mobis Groceries $100,000 divided by $5,000,000. So it's 2%. It's a pretty low ratio, therefore, the net profit margin it's basically saying every dollar in net sales for Mobis Groceries, 2% which would be two cents two pennies is gonna ultimately end up in profit. Now for the Luxury Clothing for Cats, it's a different profit margin, which is five times higher than it was for the grocery store. So Luxury Clothing for Cats has a 10% profit margin. So every dollar in sales, ten cents becomes profit. Which is a much higher profit margin for the Luxury Clothing for Cats company.
So you might be wondering well how do they have the same return on assets what is going on here if this one company has a much higher profit margin? What is responsible for this? Well, what we have is we have very different asset turnovers, so basically to get the asset turnover we take the company's net sales and then we divide it by the average total assets. So for Mobis Groceries that would be the 5 million divided by 2million so that gives you an asset turnover of 2.5. Now for the other company for Luxury Clothing for Cats, we have 1million but we're dividing it by 2million which is the average total assets. Now that gives you 0.5 for asset turnover. That's how you calculate the asset turnover ratio.
Now let's get to the interpretation of what does this means? It means this both companies in this example have the same amount of average total assets they both have 2million dollars in average total assets yet Mobis Groceries have 5million in sales where Luxury Clothing for Cats only has a million in sales. So Mobis Groceries if we just think about average total assets and net sales, they are much better at generating sales given the assets are the same.
Why does that matter? Well, think about it if Mobis Groceries has a very low-profit margin they're not making much profit every time they have $1.00 in sales but they have a lot more sales. So you think about and this is kind of nature of the industry, if you think about a grocery store there are a lot more people coming in and buying groceries in any given hour then there are people buying Luxury Clothing for Cats. So a Luxury Clothing for Cats might be a much smaller market so they have to have a higher markup of their prices there with luxury clothing for cats or if you think of luxury cars or private planes or anything like that you think of they make a lot more profit every time they make a sale but you're gonna sell a lot more groceries then you are Luxury Clothing for Cats. A lot more people want groceries than there are people want to buy high-end clothing for their cat and so, in this case, have the same ROA and it's basically a situation where Mobis Groceries isn't making much profit every time they make a sale but they're making a lot more sales. So it doesn't quite matter that they're not making as much profit as the cat clothing company every time they make a sale, those are making a lot more. So they're a lot better at generating sales given the assets they have than the Luxury Clothing for Cats company.
