A sales efficiency ratio called Fixed Asset Turnover (FAT) gauges how effectively a business uses fixed assets to generate revenue. Divide net sales by net fixed assets over a year to get this ratio.
Net fixed assets are the amount of property, plant, and equipment less accrued depreciation. An elevated fixed asset ratio often denotes improved revenue generation from fixed asset investments. This ratio is typically looked at in conjunction with profitability and leverage ratios.
What are Fixed Assets and How Do They Work?
Long-term or non-current assets, such as fixed assets, are used by businesses to produce revenue. Real estate includes items like land, buildings, machinery, equipment, furnishings, and automobiles. They frequently undergo depreciation, impairments, and dispose. All of these are routinely depreciated from their initial asset value until they are either deactivated or rendered useless.
Indicators of a high or low fixed asset turnover ratio:
If a corporation has a high fixed asset investment and poor sales performance, the FAT ratio may be low.
This is especially true for manufacturing businesses that depend on sizable equipment and structures. A low FAT may have a negative connotation if the organisation just made significant major fixed asset purchases for modernization, even if not all low ratios are bad.
The corporation may be overinvesting in fixed assets if the ratio is declining.
A high ratio
On the other hand, the majority of businesses favour a high ratio. It implies that better fixed asset management yields higher returns on asset investments.
A corporation’s ability to generate income from such assets cannot be determined with a specific percentage or range. Only by comparing a company’s most current ratio to earlier periods, as well as ratios of other businesses in a comparable industry or industry standards, can this be ascertained.
Comparing ratios of comparable types of organisations is crucial since fixed assets vary significantly from one company to the next and from one industry to the next.
Are Investors Aware of the Fixed Asset Turnover Ratio?
For investors searching for investment opportunities in sectors with capital-intensive firms, FAT may be useful in assessing and tracking the return on investment.
This evaluation helps them decide whether or not to continue investing as well as how effectively a certain organisation is operated. Additionally, it can be used to evaluate a business’ expansion to see if revenues are rising proportionately to its asset bases.
What can we infer from the turnover of fixed assets?
When we comprehend the fixed asset turnover ratio calculation, we need to know how to interpret the results.
We assume that the better the fixed asset turnover ratio, the higher it should be. This is due to the fact that a high fixed asset turnover indicates that PP&E or fixed assets are being utilised effectively and efficiently by the organisation.
A strong fixed asset turnover ratio, however, cannot be determined by a single factor. Because the mechanics and dynamics of various sectors vary, so do their favourable fixed asset turnover ratios. For instance, a cyclical firm can see a low fixed asset turnover during the off-peak period but a high one during the peak period. Therefore, comparing this statistic to the industry average is the best approach to assess it.
Furthermore, profitability is not always implied by a large fixed asset turnover. A corporation may nevertheless be unsuccessful despite using fixed assets well because of other variables like competition and high variable costs.
Applications and Relevance
To determine how effectively a business is using its machinery and equipment to generate sales, an investor or creditor will look at the fixed asset turnover ratio. Investors need to understand this idea since it enables them to estimate the return on their fixed asset investment.
On the other side, creditors look at the ratio to see if the business can produce enough cash flow from recently acquired equipment to pay back the loan that was used to buy it. In the manufacturing industry, where sizable, pricey equipment purchases are typical, this ratio is widely utilised.
On the other hand, senior management in any organisation rarely employs this ratio since they have insider knowledge of sales statistics, equipment purchases, and other elements that are difficult for outsiders to access.
Instead, the management prefers to use more precise and comprehensive data to determine the return on their investments.
If a corporation has an excessive amount of money invested in its assets, its operational capital will be excessively high.
Otherwise, if the company does not invest enough money into the purchase, it may lose sales, affecting profitability, free cash flow, and, lastly, stock price. The proper degree of investment in each asset must be determined by management.
By comparing the company’s ratio to that of other businesses in the same sector and by examining how much capital other businesses have invested in assets with a comparable composition.
The organisation can also keep track of how much they spend annually on each item and develop a pattern to analyse changes from year to year.