Question

Describe each of the following ratios and explain what types of economic activity they measure.

a) Asset turnover

b) Profit margin on sales

c) Return on assets and the two approaches mention for calculating covered in the text.

Answer 1

a) Asset turnover ratio is an efficiency ratio. It indicates the number of times the assets in the business is generating turnover or revenue to the firm. The higher the turnover ratio higher is the efficiency of assets getting used in business to generate turnover. The economic activity measured is the turnover.

b) Profit margin on sales is a profitablity ratio which measures the profit margin as a relative percentage of sales. It indicates how profitable the sales of the firm to generate net income. Higher the profitablity ratio it is better for the firm and shareholders. The economic activity measured is the net income.

c) The return on assets is the net income generated out of average total assets invested in the business. It is a profitablity and efficiency measure ratio and higher the ratio it is better for the firm.

Two approaches for calculation:

i. The net income of the firm is divided by the average total assets to calculate the return on assets

ii. Return on assets is equal to net profit margin multiplied by its asset turnover ratio.