The purpose of any business is, of course, to generate profit, so there are a variety of metrics that business owners and investors use to assess the efficiency of a company’s business model. While many popular metrics, such as the net profit margin, measure the degree to which a business is profitable, efficiency metrics measure how well a company uses what it already owns to generate profits. The fixed asset turnover ratio is one such metric.
The formula for the fixed asset turnover ratio is as follows:
For a fuller understanding of how this calculation works, it’s important to understand the individual components. Net sales, simply enough, is all operational revenue generated by the sale of goods or services, minus any deductions for returns or reduced pricing.
What Are Fixed Assets?
Fixed assets generally refer to those assets that cannot easily convert into cash. Current assets, such as marketable securities and accounts receivable, are not included in the fixed asset total. Common fixed assets are real estate, equipment, and vehicles. However, because fixed assets include all illiquid assets that benefit the operational efficiency of the company for an extended period, a company’s total fixed assets as reported on the balance sheet may include intangible assets, such as goodwill. For the fixed asset turnover ratio calculation, these intangible assets are subtracted from the total, yielding the net fixed asset figure. This is also often referred to as property, plant and equipment, or PP&E because these types of big-ticket investments typically make up the bulk of the net fixed asset total.
Some businesses’ PP&E totals can fluctuate throughout the year due to the sale or purchase of real estate or equipment. In these cases, the fixed asset turnover ratio uses the average net fixed assets. This average is calculated by adding the net fixed asset totals from the beginning and end of the calculation period and then dividing by two.
Assume company ABC has total revenues for the year of $150,000 but lost $5,000 in returned product. The total fixed assets are $84,000, but this includes $14,000 in intangible fixed assets. Since these intangibles are not included in the PP&E definition, they are subtracted from the total fixed assets. The fixed asset turnover ratio for the given period is ($150,000 – $5,000) / ($84,000 – $14,000), or 2.07. This means that for each dollar invested in PP&E, the company is generating $2.07 in net sales.
There is no hard-and-fast rule for what constitutes a good or bad fixed asset turnover ratio, so this metric should always be compared to industry standards and the ratios of other companies that are similar in size. A very equipment-heavy company, such as an auto-manufacturer, always has an inherently higher fixed asset total. If its fixed asset turnover ratio is compared out of context to a company with fewer fixed asset requirements, such as an online software retailer, the results can be misleading.
In general, a high ratio indicates that the company is making good use of its existing assets. A low ratio is an indicator either of low sales or that the business has over-invested in land or equipment that isn’t benefiting the bottom line.