What is the relationship of the assets turnover rate to the rate of return on total assets?

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Return on Total Assets (ROTA) is a key tool in directing management’s day to day activities. It provides a benchmark against which all operations can be measured. However, as a single figure it simply provides a target. To be useful in decision making, it first be broken into its components parts. It is done in two stages. First the main ratio is divided into two subsidiary ratios, and then each of these is further divided into its detailed constituents.

 In stage one, two prime subsidiary rations are identified:

 -Margin on sales percentage

-Sales to total assets ratio (asset turn)

ROTA is calculated by the fraction: EBITA/TA. I introduce the figure for sales and link it to each variable to gives you two fractions instead of one. We get the ratios (a) EBIT/sales (profit margin and (b) sales/TA (asset turn). It is simple mathematics to show that the product of these will always combine to the value of ROTA. The formula is:

ROTA = Profit Margin x Asset Turn

EBIT/TA = EBIT/Sales x Sales/TA

Example:

Rs.14/Rs.100= Rs.14/Rs.200 x Rs.200/Rs.100

14% =7% x2 time

We have derived two most important ratios, ‘profit margin’ and ‘asset turn.’ Profit margin identifies profit as a percentage of sales and is often described as the net profit margin. It is well known measure and almost universally used in the monitoring of a company’s profitability.

Asset turn ratio looks at the total sales achieved by the company in relation to its total assets, a measure that is often less emphasized in the assessment of company performance. However, its contribution to ROTA is just as powerful and important as the profit margin.

For more detail, please consult book ‘Key Management Ratios,’ by Ciaran Walsh.

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