What Is the Fixed Asset Turnover Ratio?
The fixed asset turnover ratio is a metric that measures how effectively a company generates sales using its fixed assets. There's no ideal ratio that's considered a benchmark for all industries. Instead, investors should compare a company's fixed asset turnover ratio to those of other companies in the same sector. If a company has a higher fixed asset turnover ratio than its competitors, it shows the company is using its fixed assets to generate sales better than its competitors.
- The fixed asset turnover ratio is an efficiency ratio that measures how well a company uses its fixed assets to generate sales.
- It is calculated by dividing net sales by the net of its property, plant, and equipment.
- A high ratio indicates that a company efficiently uses its fixed assets to generate sales, whereas a low ratio indicates that the firm does not efficiently use its fixed assets to generate sales.
- Investors use the ratio to determine their return on investment (ROI), and creditors use it to assess how well a company can repay loans used to purchase equipment.
Understanding the Fixed Asset Turnover Ratio
The fixed asset turnover ratio is an efficiency ratio calculated by dividing a company's net sales by its net property, plant, and equipment (property, plant, and equipment - depreciation). It measures how well a company generates sales from its property, plant, and equipment. From an investment standpoint, this ratio helps investors approximate their return on investment (ROI), especially in the equipment-laden manufacturing industry. For creditors, this ratio helps to assess how well new machinery can generate revenue to repay loans.
A high fixed asset turnover ratio often indicates that a firm effectively and efficiently uses its assets to generate revenues. A low fixed asset turnover ratio generally indicates the opposite: a firm does not use its assets effectively or to its full potential to generate revenue. The ratios alone do not confirm how effective a company uses its fixed assets. Combined with other analysis, it can give a clear picture of operations, performance, and management of assets.
Example of the Fixed Asset Turnover Ratio
Consider the example in which an investor compares the fixed asset turnover ratios of semiconductor companies AA, BB, and CC:
- Company AA had $2 million in net sales and net fixed assets of $500,000 for the year.
- Company BB had $1 million in net sales and net fixed assets of $600,000 for the year.
- Company CC had $5 million in net sales and net fixed assets of $2 million for the year.
The three companies have the following fixed asset turnover ratios:
- AA = 4.0 or ($2,000,000 / $500,000)
- BB = 1.67 ($1,000,000 / $600,000)
- CC = 2.5 ($5,000,000 / $2,000,000)
In this example, company AA has the highest fixed asset turnover ratio out of the three companies, indicating it's using its fixed assets efficiently to generate sales. However, it's important to analyze why the assets of company CC, for example, are so low compared to those of its peers. Perhaps, company CC has outsourced some of its manufacturing and, as a result, has fewer fixed assets and is more efficient because of better cost controls.
The fixed assets turnover ratio can also be calculated by factoring in accumulated depreciation, whereby net sales is divided by the difference between fixed assets and accumulated depreciation. However, an investor must be aware that if the fixed assets of a company are old, they will have a large amount of accumulated depreciation and a larger denominator, which will influence the ratio. Investors need to determine if the company is investing in new plant and equipment to foster growth in the years to come.