Posted by Shivali Anand
February 24, 2022 | 6-minute read (1067 words)
Every dollar invested in your business should create revenue or help boost profit. One measure businesses use to assess performance in this regard is the fixed asset turnover ratio, particularly businesses in capital-intensive industries such as manufacturing, where large and expensive machines are common.
The fixed asset turnover ratio is an efficiency ratio. It measures a business’s return on their investment in property, plant and equipment by comparing net sales with fixed assets.
Asset utilization ratios are frequently used by lenders and investors to gauge how well a business is doing compared to its counterparts. Often, the information they need to apply the formula is publicly available. When combined with other research, the fixed asset turnover ratio helps provide a thorough picture of a company's performance and asset management.
What is the fixed asset turnover ratio?
The fixed asset turnover ratio compares net sales to fixed assets to determine how efficiently a company is generating sales with its machinery and equipment.
Creditors and investors both rely on this method to determine how successfully a firm has used its equipment to produce revenue. Creditors are concerned with the ratio because it tells them whether a new piece of equipment will generate enough money to repay the loan used to acquire it. Investors care about this ratio because it can give them a rough idea of their ROI.
Since a business’s own management has insider information about its sales numbers, equipment purchases and other factors that aren't readily available to other users, they tend not to use the fixed asset turnover ratio very often. Instead, they use more extensive and specific data to calculate ROI on their property, plant and equipment purchases.
The formula for the fixed asset turnover ratio
The formula is derived as shown below.
| Fixed asset turnover ratio = |
net sales |
÷ |
gross fixed assets – accumulated depreciation |
| -OR- |
|
|
|
| Fixed asset turnover ratio = |
net sales |
÷ |
average net fixed assets |
A company's fixed asset turnover ratio is computed by dividing net sales by the entire value of its property, plant and equipment, excluding accumulated depreciation. As you can see, it's an easy equation. We always employ the net asset value stated on the balance sheet by deducting the cumulative depreciation from the gross equipment values, since using the gross equipment values would be deceptive.
As businesses frequently buy and sell equipment during the year, investors and creditors often use an average net asset number for the denominator, which is calculated by combining the starting and ending balances and dividing by two.
How to calculate fixed asset turnover ratio?
The fixed asset turnover ratio can be calculated using the steps below:
#1. Take stock of the company's net sales, which may be seen as a line item on the income statement.
#2. The average net fixed assets can be found on the balance sheet by taking the average of net fixed assets at the beginning and end of the month. Gross fixed assets and cumulative depreciation, on the other hand, can be recorded from the balance sheet to compute net fixed assets by subtracting accumulated depreciation from gross fixed assets.
#3. Finally, the fixed asset turnover ratio is calculated by dividing net sales by net fixed assets.
Sample application of the fixed asset turnover ratio
Ronald's House Restoration is a company that constructs custom buildings and restores older homes to their former luster. Owner Ronald is looking for a loan to help him construct a new building and expand the business. His sales for the year total $250,000, and he spent $100,000 on equipment. The equipment has accumulated $50,000 in depreciation.
The formula for calculating the fixed assets turnover ratio here is:
| Fixed asset turnover ratio = |
net sales |
÷ |
gross fixed assets – accumulated depreciation |
| 5 = |
$250,000 |
÷ |
$100,000 - $50,000 |
As you can see, Ronald generates five times the value of his assets in terms of sales. The bank should compare this indicator to similar firms in Ronald's industry. A 5x metric may be good in industry like architecture but poor for heavy equipment-dependent sectors such as automotive.
It is advised to compare your company's fixed asset turnover ratios to other firms in your sector.
What is a good fixed asset turnover ratio to aspire for?
A high fixed asset turnover ratio suggests that assets are being used effectively and that a sizable number of sales are being generated by a small number of assets. It could also indicate that the business has begun to outsource its activities after selling off its equipment. Outsourcing would retain the same level of sales while lowering the investment in equipment.
On the other hand, a low fixed asset turnover ratio implies that the firm isn't getting the most out of its assets. This may be the result of several factors. The business may, for example, be making items that no one wants to buy. Or, they may have misjudged the demand for their goods and overinvested in manufacturing machinery. The ratio could also be low due to manufacturing issues, such as a bottleneck in the supply chain that slowed output throughout the year, resulting in lower-than-expected sales.
It's important to remember that a high or low ratio doesn't automatically imply poor performance. A few other external variables will also influence this determination.
What is the fixed asset turnover ratio used for?
1. Investors and creditors use the fixed asset turnover ratio to assess a company's ability to sell its products. The ratio is critical for investors to evaluate the approximate return on fixed asset investments.
2. Alternatively, creditors evaluate the ratio to assess whether the firm can produce enough cash flow from newly acquired equipment to repay the loan. When buying pricey equipment, evaluating this ratio is essential.
3. As they have insider information about sales numbers, equipment purchases and other specifics that outsiders lack, top management rarely employ this ratio. A more defined return on investment is typically preferred by management.
4. Insufficient operating capital implies excessive asset investment. Deficient asset investment may result in lost sales, reduced profitability, free cash flow and finally, a decrease in stock price. Amounts invested in each asset must be determined by management.
5. Analyzing how much other firms in the same industry have invested in similar assets to compare the company's investment ratios. It may also track annual investments in each asset and create a pattern to compare year-on-year trends.
