Analyzing a company’s financial condition often boils down to looking at two factors: productivity and profitability. Productivity tells you how efficiently a company generates revenue, while profitability tells you how much of that revenue the company gets to keep. Investors and financial analysts gauge productivity and profitability with two simple and closely related ratios: asset turnover and profit margin.

Asset Turnover

Whatever line of business a company is in, its basic business strategy will be the same: Use its assets to generate revenue. The more revenue it gets out of each dollar’s worth of assets — the more it “turns over its assets,” in business-speak — the more efficient the company is. Analysts and investors measure this efficiency with the asset turnover ratio. To compute it, take the company’s sales revenue for a year and divide it by the average combined value of all its assets. For example, if a company had $40 million in sales and an average of $25 million in assets, its asset turnover is 40/25, or 1.6 — that is, $1.60 in sales revenue for every $1 in assets.
Profit Margin

One of the most widely known and referenced financial ratios, profit margin reveals how much of a company’s revenue becomes profit. The figure a company reports as “sales revenue” is merely the gross amount of money it gets from its customers. Its net income — another term for profit — is what is left of that revenue after the company has accounted for its expenses, including taxes. To calculate profit margin, take the company’s net income and divide it by its sales revenue. If a company had $10 million in net income on $40 million in sales, its profit margin would be 10/40 — or 25 percent.
Relationship

Asset turnover and profit margin tend to go hand in hand. Companies that operate with low profit margins need high asset turnover. Since they realize a relatively small percentage of profit with each sale, they have to do a large volume of business to turn a healthy profit in dollar terms. Grocery stores are a classic example of this. On the other hand, companies with a high profit margin may be able to get by with a lower asset turnover.
Return on Assets

Profit margin and asset turnover are so closely linked that you can combine them to produce a third commonly used financial ratio, “return on assets.” This ratio reveals how much profit the company generated for each dollar’s worth of assets. When you multiply asset turnover (sales/assets) by (net income/sales), the sales figures cancel out, and you’re left with net income/assets, which happens to be the formula for return on assets. So a company with $25 million in assets, $40 million in sales, and $10 million in net income has a return on assets of 10/25, or 0.4 — that is, 40 cents of profit for every $1 in assets. Note that this is the same figure you would get if you’d multiplied asset turnover (1.6) by profit margin (25 percent).
Getting the Figures

All the numbers used to calculate these ratios can be found in a company’s annual financial statements. Sales revenue will generally be the top line of the income statement. Net income is usually the bottom line of the income statement. Total assets can be found on the balance sheet. To determine the average total assets for a year, add together the asset totals from the beginning of the year and the end of the year, and then divide by two.