Fixed Asset Turnover Ratio is an efficiency ratio that depicts how well the business has utilized fixed assets in order to generate sales. It measures business returns on investment in plants, properties, equipment, and other fixed assets by comparison of net sales with fixed assets.
Here is the formula to calculate the ratio,
Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets
Here, Sales are taken annually while average fixed assets are calculated by dividing the opening balance of fixed assets at the beginning of the year and closing balance of fixed assets at the end of the year by 2.
Fixed Assets Balance are net of accumulated depreciation at the end of the period.
The reason for taking average fixed assets is that businesses often purchase or sell the fixed assets during the year and also due to the fact that this ratio is mainly used in the analysis by manufacturing concerns.
Now, let us look at the advantages and limitations of calculation of fixed assets turnover ratio:
- Fit for Manufacturing Industry: Bulk of investments are made in manufacturing industry. Manufacturing concerns buy a lot of plants, equipment and other fixed assets. Fixed Assets Turnover ratio gives a good edge to manufacturing concerns, a different view in analyzing the return on assets with respect to top line growth. The high turnover ratio indicates that fixed assets are working efficiently and effectively in generating good number of sales.
- Makes Comparison easy for investors: Investors analyze this ratio year over year reflecting the efficiency increment or decrement of fixed assets. It also helps them to know when the reinvestments should be made on fixed assets so as to keep in line with growth guidelines.
- Helps in planning for Asset Sale and Investment: If fixed assets turnover ratio has suddenly dropped, it means that fixed assets to the operations has become obsolete and it needs to be sold. The comparison with other companies in the same domain also states that when new plants, machineries and equipment should be bought.
- Industry Limitations: It is useful mainly in comparing companies across manufacturing concerns. For asset light industries like those based heavily on technologies, fixed assets turnover ratio cannot be put to play.
- Does not take Profit into account: The fixed assets turnover ratio only measures correlation between fixed assets and net sales and not the cause of what impacted the figures. A drop in asset turnover ratio can lead management on useless manhunt chasing for obsolete assets, while in reality, revenue has dropped for independent reason. Due to such drawback, fixed assets turnover ratio should be analyzed over a variety of profit and revenue ratios.
- Difference in Accounting Policies: Two companies in the same industry or over separate industry can have different accounting policy with regards to depreciation methods. This skews the results of comparison of fixed assets turnover ratio over the industry. There can be cases where two companies having similar asset model and sales can show different fixed assets turnover ratio due to differences in accounting policies of depreciation. Hence, this ratio suffers from management discretion over employment of accounting policies with respect to sales and fixed assets.
- Performance Subject to Manipulation: The Fixed Assets turnover ratio is helpful in performing entities having high value investments in assets where board of directors want to assess the efficiency of these fixed assets in relation to turnover of the company. However, the major limitation, the fixed asset turnover ratio suffers is in its use as performance measuring yardstock as it encourages the manager to keep using the old asset without providing for the replacement costs of new one.
- To take full advantage of fixed assets turnover ratio, one should also correlate profit ratios with this ratio in order to get larger picture.