Fixed asset turnover ratio
/What is the Fixed Asset Turnover Ratio?
The fixed asset turnover ratio compares net sales to net fixed assets. It is used to evaluate the ability of management to generate sales from its investment in fixed assets. A high ratio indicates that a business is doing an effective job of generating sales with a relatively small amount of fixed assets. In addition, it may be outsourcing work to avoid investing in fixed assets, or selling off excess fixed asset capacity.
The concept of the fixed asset turnover ratio is most useful to an outside observer, who wants to know how well a business is employing its assets to generate sales. A corporate insider has access to more detailed information about the usage of specific fixed assets, and so would be less inclined to employ this ratio.
Implications of a Low Fixed Asset Turnover Ratio
A low fixed asset turnover ratio indicates that a business is over-invested in fixed assets. A low ratio may also indicate that a business needs to issue new products to revive its sales. Alternatively, it may have made a large investment in fixed assets, with a time delay before the new assets start to generate sales. Another possibility is that management has invested in areas that do not increase the capacity of the bottleneck operation, resulting in no additional throughput.
Indications of a High Fixed Asset Turnover Ratio
A high fixed asset turnover ratio indicates that an organization’s management team is prudent in making investments in fixed assets. They may be eliminating excess assets promptly, rather than keeping them on the books. Managers may also be shifting production work to outsourcers, who are making investments in fixed assets instead of the company. Another possibility is that management is utilizing the existing assets continually, perhaps across all three shifts, in order to maximize their usage.
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How to Calculate the Fixed Asset Turnover Ratio
The formula for the ratio is to subtract accumulated depreciation from gross fixed assets, and divide that amount into net annual sales. It may be necessary to obtain an average fixed asset figure, if the amount varies significantly over time. Do not include intangible assets in the denominator, since it can skew the results. The formula is:
Net annual sales ÷ (Gross fixed assets - Accumulated depreciation) = Fixed asset turnover ratio
Example of the Fixed Asset Turnover Ratio
ABC Company has gross fixed assets of $5,000,000 and accumulated depreciation of $2,000,000. Sales over the last 12 months totaled $9,000,000. The calculation of ABC's fixed asset turnover ratio is:
$9,000,000 Net sales ÷ ($5,000,000 Gross fixed assets - $2,000,000 Accumulated depreciation)
= 3.0 Turnover per year
Problems with the Fixed Asset Turnover Ratio
Several cautions regarding the use of this measurement are noted below:
Industry specific. The fixed asset turnover ratio is most useful in a "heavy industry," such as automobile manufacturing, where a large capital investment is required in order to do business. In other industries, such as software development, the fixed asset investment is so meager that the ratio is not of much use.
Skewed by accelerate depreciation. A potential problem with this ratio may arise if a company uses accelerated depreciation, such as the double declining balance method, since this artificially reduces the amount of net fixed assets in the denominator of the calculation and makes turnover appear higher than it really should be.
Skewed by re-investment rate. Ongoing depreciation will inevitably reduce the amount of the denominator, so the turnover ratio will rise over time, unless the company is investing an equivalent amount in new fixed assets to replace older ones. Thus, a business whose management team deliberately decides not to re-invest in its fixed assets will experience a gradual improvement in its fixed asset ratio for a period of time, after which its decrepit asset base will be unable to manufacture goods in an efficient manner.
Similar Concepts
The fixed asset turnover ratio is similar to the tangible asset ratio, which does not include the net cost of intangible assets in the denominator. The ratio is also sometimes known as the fixed asset ratio.