How well is a company using its fixed assets? The fixed asset turnover ratio gives important clues. Read on to learn how to interpret this extremely useful financial measurement.
Financial ratios such as the fixed asset turnover help financial analysts, management, and investors alike to make critical decisions whether to invest further, and they also determine how well a particular business is being run.Of course, the ratios have real meaning when compared to industrial standards and averages.
The fixed assets turnover ratio is used to determine how efficiently a company or operation is at using its fixed assets to generate sales. A low turnover suggests that the fixed assets are being underutilized or that there are more assets than can be effectively used.
On the other hand, a very high turnover ratio may suggest that the operation is running at peak efficiency; a high turnover may also mean that the plant is running at full capacity or is bursting at the seams and will need further capital investments or upgrades.
Measuring Company Efficiency
To calculate the fixed assets turnover ratio, take the net sales/net revenue (the amount after deducting returns, allowances for damaged goods, and discounts) and divide it by the total fixed assets. In brief, the fixed assets turnover ratio formula is: Net Sales/Plant and Equipment.
In some applications the “cost of goods sold" is used instead of net sales, such that the ratio is calculated using this formula: Fixed Asset Turnover Ratio = Cost of Goods Sold/Capital Employed.As long as the same formula is used to calculate the ratio for all companies being analyzed and compared, there is no real harm in using either variation.
The advantage in using one formula over another is left to the analyst to decide or may be determined by the intricacies of the analysis being done.
How to Interpret the Fixed Assets Turnover Ratio
The formula is useful in analyzing growth companies to see if they are growing sales in proportion to their asset bases. The fixed assets turnover ratio really has little meaning except when it is put in the context of industrial averages, and consideration is made whether new capital expenditures recently undertaken were such that they could skew the ratio. For example, the turnover ratio will be lower just after a significant amount of fixed asset is acquired to upgrade or expand the plant facilities.
A low asset turnover ratio may also suggest that a plant is obsolete and needs to be upgraded, an undertaking that can negatively impact cash reserves, the debt exposure, and cash flow for the medium to long term. Quite naturally, it will take some time for these acquisitions to start making a positive impact on revenue and, by extension, the asset turnover figures.
While the fixed asset turnover ratio is effective in measuring how efficiently a business is using its fixed assets, one has to consider two points: Is the actual ratio skewed by new acquisitions that have not yet started to make contributions to sales? How well are similar companies doing?
You need to know this in order to get an idea of the industrial norm in the current economic environment. Even so, the ratio is a great tool to help managers and investors make strategic decisions on the way forward.
Image credit: Flickr, “How do I calculate the fixed assets turnover ratio?" by tompagenet