What Is the Fixed Asset Turnover Ratio & How Is It Calculated?
Apr 16, 2021 | By Michael Whitmire
When it comes to improving or predicting a company’s performance, the leadership team has a lot of unique insight. They have access to all sorts of financial reports and data not shared with the outside world. External stakeholders and investors, on the other hand, often have only the financial statements to go by (audited or not, depending on the company).
This means that lenders and investors often rely on financial ratios and financial statement analysis. This allows them to perform a valuation based only on publicly available information provided by the company. Fixed asset turnover ratio is one of the ratios used to measure company performance. It’s especially helpful in capital-intensive industries like the manufacturing industry.
Calculating the Fixed Asset Turnover ratio is fairly simple. First, subtract accumulated depreciation from your total assets on the balance sheet to arrive at the book value of the company’s assets. Next, divide net sales (from the income statement) by that net asset value. Since many assets are bought and sold during the year, investors and lenders often add the beginning balance and ending balance of fixed assets and divide by 2 to arrive at average net fixed assets.
What Does Fixed Asset Turnover Tell You?
Fixed Asset Turnover is an efficiency ratio. It tells you how well a company is using its fixed assets to generate income, also known as a return on assets. Using the example of a manufacturing company, this ratio tells you how efficiently the company is using every dollar it invests in machinery and equipment to generate revenue.
This ratio is especially helpful for lenders providing money for new equipment (and wanting to know they can be repaid) or investors who want to estimate future sales revenue and cash flow based on asset purchases. For instance, if a manufacturing company is inefficient at generating revenue from one of its facilities, it’s unlikely that lenders and investors will feel comfortable financing expansion for a new facility.
Is a Higher or Lower Asset Turnover Ratio Better?
When you calculate this ratio, you’ll see how many times you generate your fixed asset value in revenue each year. For instance, if you have $1m in average fixed assets and have $2.5m in net sales for the year, your fixed asset turnover ratio will be 2.5.
A low fixed asset turnover ratio shows that a company isn’t very efficient at using its assets to generate revenue. A high ratio, on the other hand, shows greater efficiency. Fixed Asset Turnover Ratio is a great way to benchmark one company against another or against an industry average. In fact, what’s considered a “good” or “bad” ratio is very dependent on the industry.
Some industries don’t really lend themselves to this ratio at all and should be measured in other ways. For instance, the inventory turnover ratio may be much more helpful in retail, where inventory is a major asset.
Every industry needs to be measured in a different way, depending on how it generates revenue. For some, it’s heavy on fixed assets like PP&E, while others depend mostly on current assets like cash, receivables, or inventory. The different efficiency ratios track how the company uses assets to generate revenue, and vary mostly by changing the denominator in the formula to fit the asset base of the company (fixed assets, current assets, working capital, etc.).
Keep in mind that the fixed asset turnover is just part of the picture. It shows how efficiently you generate revenue from assets, but that on its own isn’t enough. The gross sales generated can’t tell you everything you need to know. You’ll also want to look at profitability ratios like profit margin to see how much of that revenue makes it the bottom line net income.
Fixed asset turnover ratio is helpful for measuring how efficiently a company uses its fixed assets to generate revenue without being inherently capital intensive. The higher the ratio, the more efficient. To be truly insightful, though, one needs to measure the trend of the ratio over time or compare it against a benchmark for a specific industry.