What’s it: The fixed-asset-turnover ratio is a financial ratio to measure how productively and efficiently a company uses its fixed assets to generate revenue. Fixed assets include production machinery, equipment, motor vehicles, buildings, etc.
We calculate this ratio by dividing revenue by the average fixed assets. The higher the ratio, the better. That’s because the company can generate more revenue for each fixed asset it owns.
In addition to historical comparisons, comparing the ratio to competing companies or industry averages is essential to provide deeper insight.
How to calculate fixed asset turnover ratio and examples
Calculating the fixed asset turnover ratio is easy. We only need an arithmetic operation by dividing revenue by total fixed assets.
We can find the revenue figures on the income statement. And, for fixed assets, you can find them on the balance sheet in the non-current assets section. Companies may present it as property, plant, and equipment (PP&E). Fixed asset figures on the balance sheet are net fixed assets because they have been adjusted for accumulated depreciation.
The following is the fixed asset turnover ratio formula:
- Fixed asset turnover ratio = Revenue / Average fixed assets
The average fixed asset is calculated by adding the current year’s book value by the previous year’s, divided by 2.
For example, a company reports sales of $5 million in 2021. The company’s balance sheet presents fixed assets of $1.2 million in 2020 and $1.3 million in 2021.
Applying the above formula, the company’s fixed asset turnover ratio is 4.00 = $5 million / {($1.2 million + $1.3 million)/2}.
How to interpret fixed asset turnover ratio?
Fixed asset turnover is important to reveal how efficiently a company generates revenue from its fixed assets.
Fixed assets are long-term investments; because of this, they are presented in the non-current assets section. And they can wear and tear, making their productivity decline over time – and therefore, companies depreciate them over time. So, companies should make the most of it.
A higher fixed asset turnover is better because it shows the company uses its fixed assets more efficiently. As a result, every dollar invested in fixed assets generates more revenue.
Conversely, a low ratio may indicate operating inefficiency. The reason could be due to investing too much in fixed assets without an adequate increase in sales. The economic downturn and lack of competition were other reasons which resulted in a significant drop in sales.
Is high asset turnover always good?
We need to compare the company’s ratio to peer companies or the industry average to draw conclusions. It provides a more objective basis for evaluation. We need to consider several factors such as:
- Industry type
- Company age
- Company product type
Industry type
If the ratio is high, the company needs to invest more in capital assets (plant, property, equipment) to support its sales. Otherwise, future sales will not be optimal when market demand remains high due to insufficient capacity.
Say the company then invests in fixed assets. It also carries risks. If future demand declines, the company faces excess capacity, which increases costs.
And, if competitors make similar investments, the market faces excess supply. As a result, it will depress the market price and profitability of all the players in the market. This situation often occurs in capital-intensive industries.
On the other hand, a low ratio does not necessarily mean inefficiency. That may be because the company operates in a capital-intensive industry. Because they are highly dependent on fixed assets (such as heavy machinery), capital-intensive industries often have low fixed asset turnover.
Company age
The company age can also affect variations in fixed asset turnover ratios. Again, this is because new companies have different characteristics from companies operating for a long time.
New companies have relatively new assets, so accumulated depreciation is also relatively low. In contrast, companies with older assets have depreciated their assets for longer.
As a result, the net fixed assets of new companies tend to be higher than those of older companies. Moreover, new firms tend to have lower fixed asset turnover ratios because the denominator is higher.
Types of products
The product type has implications for variations in the fixed asset turnover ratio. For example, notice the difference between a manufacturing company and an internet service company. They have very contrasting characteristics.
Manufacturing companies have much higher fixed assets than internet service companies. Thus, manufacturing companies’ fixed asset turnover ratio will be lower than internet service companies.
Why is the asset turnover ratio declining?
Several reasons explain why the fixed asset turnover ratio declined. First, the company may invest too much in property, plant, and equipment (PP&E). When the company makes a significant purchase, we need to monitor this ratio in the following years to see whether the new fixed assets contributed to the increase in sales or not.
Second, some companies can also lose revenue due to weak market demand during a recession. Sales are declining, and inventory is piling up. When sales fall, while production and assets remain unchanged, this ratio falls.
Third, a decline can also occur because sales are seasonal. Thus, the ratio is lower during regular periods and higher during peak periods due to higher sales.
Special note
The inventory turnover ratio does not tell us about a company’s ability to generate profits or cash flow. It only uses the revenue measure.
For example, a company might report a high ratio but weak cash flow because most sales are on credit. The company has not yet received payment for the products it has shipped. An increase in sales only leads to a buildup of accounts receivable, not an increase in cash inflows.
So, even though it seems effective in managing fixed assets. However, companies may face liquidity problems, where cash inflows are insufficient to pay bills such as to suppliers or creditors.
For this reason, we cannot isolate this ratio alone to draw conclusions. Instead, we should read it along with other metrics such as accounts receivable turnover ratio, accounts receivable growth, and revenue growth.
What to read next
- Activity Ratio: Types, Formulas, and Interpretations
- Inventory Turnover Ratio: Formula, Calculation and How to Read It
- Days of Inventory on Hand: Formula and How to Calculate
- Accounts Receivable Turnover: Formula, Calculation, How to Read It
- Days Sales Outstanding: Formula, How to Calculate and Read It
- Accounts Payable Turnover Ratio: How To Calculate And Read It
- Days Payable Outstanding: How to Calculate and Interpret it
- Working Capital Turnover: Formula, Calculation, and Interpretation
- Fixed Assets Turnover Ratio: How to Calculate and Interpret
- Asset Turnover Ratio: Calculation and Interpretation
