The Fixed Asset Turnover Ratio is a measure that reflects how much in sales a company has been able to produce with its current fixed assets. It is an important metric for manufacturing and capital intensive businesses whose sales rely heavily on the performance and efficiency of its fixed assets.
What is the Fixed Asset Turnover Ratio?
Contents
The Fixed Assets Turnover Ratio is employed by analysts and investors to determine the business capacity to produce sales from its capital expenditures. A company that has several productive fixed assets such as plants, machinery, vehicles and heavy equipment can operate at different capacities, and depending on the efficiency of its processes and its ability to produce and sell its goods, its sales will either be increased or decreased.
Imagine a business that has several plants operating at 50% of their installed capacity. A business in such situation will probably have a low Fixed Asset Turnover Ratio, as it is not taking advantage of its assets as much as it should. Therefore, a wise decision may be to shut down one of the plants, sell the assets and consolidate the operation into less facilities that may operate at full capacity.
Fixed Asset Turnover Ratio Formula
The formula to estimate the Fixed Asset Turnover Ratio is:
FAT = Net Sales / Average Net Fixed Assets
Fixed Asset Turnover Ratio Equation Components
Net Sales: Total sales for a given time period after any discounts, markdowns or any other type of deductions are subtracted.
Average Net Fixed Assets: The total value of a company’s fixed assets minus accumulated depreciation at the beginning of the period plus the total value of fixed assets minus accumulated depreciation by the end of the time period, divided by 2.
The result of the formula will indicate the amount of sales that were generated throughout the time period for each dollar invested in fixed assets.
Fixed Asset Turnover Example
Start Airlines is a company that operates flights from and to many different cities within Asia. They currently have a fleet of 5 working airplanes along with all the equipment and facilities necessary for the business to operate adequately.
A new Chief Financial Officer recently took charge and since the business is a capital intensive one, the first thing he wanted to know about the company is how has its Fixed Asset Turnover Ratio behaved in the last 3 years. One of the analysts pulled the following information to calculate the turnover ratio:
Net Sales2016: $34,560,000 Avg. Net Fixed Assets2016: $12,450,000
Net Sales2017: $27,600,000 Avg. Net Fixed Assets2017: $11,120,000
Net Sales2018: $24,300,000 Avg. Net Fixed Assets2018: $10,430,000
The turnover ratio for each year can be then calculated as follows:
Fixed Asset Turnover Ratio2016 = $34,560,000 / $12,450,000 = 2.78
Fixed Asset Turnover Ratio2017 = $27,600,000 / $11,120,000 = 2.48
Fixed Asset Turnover Ratio2018 = $24,300,000 / $10,430,000 = 2.32
According to these estimations, the company’s FAT has been decreasing consistently in the last 3 years. It appears the the company’s airplane fleet is old now and some of them have to be constantly sent to the workshop, which affects the flight frequencies and also creates customer satisfaction issues. This is the main reason why sales have also been decreasing.
Fixed Asset Turnover Ratio Analysis
As you can see, there are many conclusions that can be drafted from an analysis of a fixed asset turnover ratio, for a company that relies heavily on these assets to produce sales. It is hard to pinpoint what would be a healthy range for this ratio, as the number varies from one industry to the other. Yet, the higher the number, the better the performance of the business.
A low turnover ratio means that the company is not getting enough out of the assets it has, which in turn affects the company’s capacity to produce a return on the investment made on such assets.
Some of the reasons why the company may not be able to produce enough sales out of these assets may be:
- The assets are old and their efficiency is reduced.
- The company’s manufacturing technology is outdated.
- The company is operating with a low utilized capacity.
Any of these reasons, along with some others, may cause a low Fixed Asset Turnover Ratio. For example, if a company’s fixed asset fleet hasn’t been updated and the market is moving towards cutting-edge technology, eventually that company will suffer from a reduction in its competitiveness, which will reduce sales and drive the ratio down.
Additionally, human resources also play a big role in increasing this ratio. An efficient management team that constantly looks for ways to increase productivity and determines the best practices for each process will eventually drive the ratio up, as a larger output will be produced from the same assets.
For Start Airlines, the CFO identified that the problem with sales may be related to the obsolescence of the business’ fixed assets. A reinvestment program may have to be implemented to substitute the current units for new ones that can increase the fleet’s productivity. One alternative would be to sell the current fleet or mortgage it to progressively acquire the new units. In any case, if this replacements are not in place soon the business will continue to suffer and the ratio will continue to decrease over time.
Fixed Asset Turnover Uses, Cautions, Pitfalls
The Fixed Asset Turnover Ratio should be carefully incorporated to the overall analysis of a business, depending on which type of business it is. This metric should gain importance if a business is a capital intensive one, or a manufacturing business, or a transportation business, all of which rely heavily on their fixed assets to produce revenues.
Contrary to that, relying on the Fixed Asset Turnover Ratio as an indicator of efficiency or performance for a ‘soft’ business, which is one whose sales have a low correlation to its fixed assets, will probably lead the analyst towards distorted conclusions.
That said, one important warning regarding this metric would be to look out for potential fixed asset revaluations or suspicious write offs that may be done in order to reduced the value of fixed assets to boost the Fixed Asset Turnover Rate to make the company look much more efficient or productive than it actually is.