What is Fixed asset turnover ratio
The fixed asset turnover ratio compares net sales to net fixed assets. It is used to evaluate the operating performance of a business. A high ratio indicates that a business is:
- Doing an effective job of generating sales with a relatively small amount of fixed assets
- Outsourcing work to avoid investing in fixed assets
- Selling off excess fixed asset capacity
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A low ratio indicates that a business:
- Is overinvested in fixed assets
- Needs to issue new products to revive its sales
- Has made a large investment in fixed assets, with a time delay before the new assets start generating revenues
- Has invested in areas that do not increase the capacity of the bottleneck operation, resulting in no additional throughput
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.
The formula for the ratio is to subtract accumulated depreciation from gross fixed assets, and divide 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)
For example, 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
Here are several cautions regarding the use of this measurement:
- 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.
- Accelerated 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.
- Re-investment impact. 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.
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.
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