Similar to the total asset turnover ratio, this ratio measures the efficiency with which the fixed assets of a company are employed, how well the fixed assets are utilized to generate revenue. In other words, it measures sales per dollar of investment in fixed assets. Analysts prefer this measure of effectiveness since fixed assets are more closely related to the production process rather than current assets like cash and accounts receivables.
Fixed Asset Turnover
When calculating a companies fixed asset turnover ratio, it is important that you calculate the net fixed assets, which is simply the current assets that a company owns minus the accumulated depreciation of those assets.
A Fixed Asset Turnover of 1.6× indicates that the firm generated $1.60 in sales from every $1 invested in fixed assets. A large ratio generally indicates a high degree of efficiency in asset utilization, alternatively a small ratio reflects inefficient use of assets.
Putting these numbers into a deeper perspective, a company with a high fixed asset turnover ratio may:
-Not need a large number of fixed assets to effectively provide their service
-Instead of purchasing fixed assets, to avoid depreciation they may rent these assets.
Whereas a company with a low fixed asset turnover ratio may:
-Have to purchase a large amount of fixed assets at a given time, to execute a job that will produce revenue in the future
-Has purchased too many fixed assets and is doing a poor job generating revenue from them
Here is a simple calculation of the fixed asset turnover ratio:
Joes company has a total of 10 million dollars in fixed assets, and these assets have depreciated 3.5 million dollars. Joe has generated 20 million dollars in sales over the last year.
20 000 000 in sales
10 000 000 in assets – 3 500 000 in depreciation
3.07 Turnover rate
However, in interpreting this ratio, it is important to keep in mind that when the fixed assets of the firm become old and substantially depreciated, the fixed asset turnover ratio tends to be high because the denominator of the ratio is very low.
Take note of the following precautions when using the fixed asset turnover ratio when analyzing a company:
– A company who simply does not want to re-invest into new fixed assets, may show a higher ratio initially because depreciation eventually lowers over time(in dollar amount). Take a new vehicle for example; A brand new vehicle depreciating 10% a year will lose more dollar value than a 10 year old vehicle depreciating the same percentage amount. Companies will show initial higher ratios, but depreciated equipment may fail over time, restricting their ability to produce a product.
– A internet marketing company may need little to no fixed assets to produce a profitable end product, so their ratios may be alarmingly high.