A fixed asset turnover ratio is an efficiency ratio that shows the return received by a company on the investments made by them in fixed assets such as plant, machinery, equipment, etc., in relation to the total sales generated. In other words, it measures how efficiently a company uses its fixed assets to make sales.
Creditors and investors refer to this ratio to identify the efficiency of the company in managing its fixed assets. They do so to interpret the returns they might earn on their investments made in the company and make sure that the earnings/revenues from the equipment are enough so that the company can pay back the loans that it has taken for it.
The formula for calculating the fixed asset turnover ratio
FAT Ratio= Net sales/ Average Fixed Assets
Net sales= Gross Sales-(Sales Return+Allowances)
Average Fixed Asset= Net Asset at the beginning of the year + closing balance/2
Though there is no ideal ratio that could be set as a benchmark, the efficiency of the company is usually determined by comparing the fixed asset turnover ratio with its past records and with other competitors who exists in the same industry.
A higher fixed asset turnover ratio indicates greater efficiency in the management of fixed assets by the company and that greater sales are generated using the fixed assets. A higher ratio could be because the company has started outsourcing its manufacturing which keeps its sales constant and the average fixed asset requirement low.
A lower ratio indicates inefficiency on the part of the company to utilize its assets to generate sales, which might be due to the production of items that are not in demand, overestimation of demand and therefore excess inventory and other manufacturing problems.
M/S XYZ and M/S ABC are a furniture manufacturing company that makes the office as well as home furniture. The sales for the year 2018 and the average fixed assets are as follows:
Average Fixed Asset
FAT Ratio = Net Sales/ Average Fixed Assets
For M/S XYZ =3.16
For M/S ABC =4.53
Given that both the companies belong to the same industry, the ratio of company ABC is higher than that of XYZ which implies the efficiency of company ABC is better.
Let us look at another example,
A company manufacturing tires have fixed assets worth of Rs 1,00,000 with accumulated depreciation of Rs 30,000. The sales of the company in the current year are Rs 2,80,000.
Fixed asset turnover ratio = 2,80,000 / (1,00,000 - 30,000) = 4.
The example indicates that the company has achieved a ratio of 4, i.e., it has used fixed assets 4 times.
The comparison of companies based on this ratio is possible only if they belong to a similar industry. Also, the industries which utilize light assets often do not give prompt and correct results, such as IT industries.
Profit is not considered
The FAT ratio only measures the correlation between a fixed asset and net sales and not the cause of what impacts those figures. A reduction in such turnover ratio can lead to the management searching for obsolete assets, while in reality, revenue might have reduced due to independent reasons. Therefore, the fixed asset turnover ratio should be analyzed over a variety of profit and revenue ratios.
Different Accounting Policies
Companies in the same or separate industry can have different accounting policies concerning the depreciation methods followed. This results in a difference in the results of a comparison of fixed assets turnover ratio over the industry.
Two companies having similar asset model and sales might show different fixed assets turnover ratio because of differences in accounting policies of depreciation. Hence, it is subject to management’s discretion over the use of accounting policies with respect to sales and fixed assets.
Consideration of cyclic sales
The companies which experience a cyclic or seasonal sale might show the worst ratio during slow periods or during off-seasons. Therefore, the FAT ratio should be checked during both on and off-season of sales for the company.
Outsourcing of activities
Companies might even outsource their manufacturing activities to other enterprises which reduces the need for them to own fixed assets such as equipment, machinery, etc. which in turn might adversely affect the fixed asset turnover ratio even though the sales are better then estimated.
Difference between fixed asset turnover ratio and total asset turnover ratio
As seen above, the fixed asset turnover ratio defines the relationship between the fixed assets owned by the company and the sales generated by it. A higher ratio shows good efficiency and vis-à-vis. This ratio is usually not very consistent because the value of the fixed asset is continuously depreciating even when the sales are constant.
FAT Ratio= Net Sales/Average Fixed Assets
The total assets turnover ratio is a ratio that shows the relationship between the total assets of the company and its sales. A high total asset turnover ratio shows good efficiency of the company. A lower ratio reflects many problems such as unsold inventory or underutilization of fixed assets.
TAT Ratio= Net Sales/Average Total Assets
How does the Fixed Asset Turnover Ratio measure the efficiency of the company?
As we learned from the above-mentioned information, the Fixed Asset Turnover Ratio measures the relationship between the revenue earned by the company in the form of sales and its fixed assets. It clearly shows how much sales is generated from a fixed asset employed in the company which may be a plant, machinery, equipment, etc.
This ratio is an indicator of the efficiency of the company because it brings into account the productivity of the company and how well a business is run by management. For example, If the company has invested large amounts in its assets, then their operating capital will be too high. However, if the company does not have invested enough in its assets, then the company might end up losing sales which will hurt its profitability, free cash flow and eventually stock price. Therefore, management needs to determine the right amount of investment in each of their assets in order to maintain its efficiency.
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