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What is a fixed asset turnover ratio?
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What Is Fixed Asset Turnover Ratio
The fixed asset turnover ratio is a type of efficiency ratio measuring a company’s ability to generate net sales using its fixed assets.
In other words, this ratio allows you to see how well the company is able to use its property, plant, and equipment (PP&E) to generate net sales.
The objective of calculating a company’s fixed asset turnover ratio is to assess a company’s operating performance and how well it uses its fixed-asset investments to generate a return.
When a company’s fixed asset turnover ratio is high, it means that the company is able to generate good revenues using its fixed-asset investments.
On the other hand, a low fixed asset turnover ratio means that the company is not efficiently using its fixed assets to generate a return to the business.
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Fixed Asset Turnover Ratio Formula
The fixed asset turnover ratio formula is essentially a company’s net sales divided by its average fixed assets:
Fixed Asset Turnover Ratio = Net Sales / Average Fixed Assets
A company’s net sales is obtained by taking a company’s gross sales and deducting any returns and allowances.
The average fixed assets is obtained by taking the net fixed assets at the beginning of the period, less the net fixed assets at the end of the period, and the result is divided by two.
When To Use Fixed Asset Turnover Ratio
Companies that make a higher level of investments in fixed assets to generate sales are those that are likely to calculate their fixed asset turnover ratio.
For example, a manufacturing company, transportation company, or industrial firm will generally have significant fixed asset investments.
As a result, to determine whether or not the company is efficiently using its fixed assets to generate sales, the fixed asset turnover ratio is highly useful.
The more a company is able to generate sales using its fixed assets, the better it is monetizing its fixed assets.
Conversely, if the company is not using its fixed assets to their maximum potential or are inefficient, it will show a lower fixed asset turnover ratio.
Companies that make important investments in fixed assets should regularly assess their ability to use their fixed assets to generate a return so they can see how they are performing over time.
It’s also useful to assess a company’s ratio with that of its peers and competitors in the same industry to see how well the company is doing compared to the others.
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Interpreting The Fixed Asset Turnover Ratio
Just like most other financial ratios, the fixed asset turnover ratio can provide useful information but should be considered with other ratios.
Calculating the fixed asset turnover ratio alone and reaching conclusions may not be appropriate as a company’s operating efficiency should be considered holistically.
Now, when you measure a company’s operating efficiency using the fixed asset turnover ratio, the higher the ratio, the better the company is using its fixed assets to generate net sales.
For example, if a manufacturing company has invested $5 million in manufacturing equipment and was able to generate $50 million in net sales with it, its ratio will be 10 which appears to be quite good.
On the other hand, if a company’s fixed asset turnover ratio is low, it means that it is generating a lower level of net sales for its fixed asset investments.
For instance, if the same manufacturing company that invested $5 million in its equipment only generates $500 thousand in net sales with it, its ratio is 0.1 which does not appear to be good at first glance.
To properly interpret the fixed asset turnover ratio, you should look at a company’s historical records to see how its ratio has evolved over time.
Also, it’s useful to compare the ratio to similar companies in the same industry to see if the company is on par, doing better, or worse than its competitors.
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Fixed Asset Turnover Ratio Limitations
Although the fixed asset ratio is useful in measuring a company’s operating efficiency, there are some limitations that you should consider.
The most important limitation is that the fixed asset ratio does not provide any useful information about a company’s profitability.
In other words, a company can have a high fixed asset ratio without being highly profitable.
Also, this ratio does not speak to the company’s ability to generate cash flow.
As a result, a company can be highly leveraged, expose investors to default risk, and have poor profitability while showing a high asset turnover ratio.
Also, a company’s management can manipulate this ratio by outsourcing production.
When the production is outsourced, the company will no longer need to make as much investments in fixed assets.
With less fixed assets on the balance sheet, the management can show a higher ratio.
Another limitation is that it’s difficult to compare companies in different industries as their reliance on fixed assets to generate sales may be different.
An e-commerce business will not have as much investments in fixed assets as a manufacturing business.
So when you’re comparing companies in different industries, you should consider other operating efficiency ratios to make a more informed decision.
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Fixed Asset Turnover Ratio FAQ
What is a good fixed asset turnover ratio?
Just like most other financial ratios, there is no specific ratio that is considered good or bad.
You should evaluate a company’s overall performance and use the fixed asset turnover ratio as part of a broader evaluation.
Typically, a company that is able to generate more than the industry average is in a good position.
If you have a ratio above 1, it means that you are generating at least $1 for every $1 invested in fixed assets.
This may be good for companies in some industries but be bad in other industries.
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Is a high fixed asset turnover better?
A high fixed asset turnover ratio is not necessarily better all the time, although it can be.
A company can have a higher fixed asset turnover ratio although it may not be more efficient operationally.
For example, a company can choose not to invest any more in fixed assets leading to a higher ratio (as the denominator is smaller).
However, without proper investment in fixed assets, the company may struggle down the road.
Also, a company can use accelerated depreciation methods to account for the book value of their fixed assets leading to a higher fixed asset turnover ratio.
However, this does not mean that the assets were being used more productively.
How do you improve your fixed asset turnover ratio?
You can improve your fixed asset turnover ratio by taking various measures, such as:
- Improve your inventory management
- Improve your sales
- Lease assets instead of buying
- Outsource production
- Invest in technology
- Invest in useful fixed assets
What is the difference between fixed asset turnover ratio and asset turnover ratio?
The main difference between the fixed asset turnover ratio and asset turnover ratio is that the first one considers the long-term assets (or non-current assets) whereas the second one considers all assets.
Takeaways
So there you have it folks!
What is fixed asset turnover?
In a nutshell, fixed asset turnover is an efficiency ratio allowing you to measure how well a company is using its fixed assets to generate sales.
You essentially take your net sales in a given period of time and divided it by your average fixed assets.
The fixed assets are tangible long-term assets including property, plants, and equipment, less any accumulated depreciation.
The higher the ratio, the better the company is using its fixed assets to generate sales.
The lower the ratio, the company may not be efficiently using its fixed assets to generate sales.
Now that you know what the fixed asset turnover ratio is and how it works, good luck with your research!
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