Fixed Asset Turnover Ratio: Definition, Formula & Calculation

Overview and definition  

What is fixed asset turnover?  

A financial metric that measures how efficiently a company uses its fixed assets to generate revenue. It evaluates whether the business is getting the most out of its long-term investments in physical assets like machinery, buildings, and equipment.  

What is the FAT ratio?  

‘FAT ratio’ is an abbreviation of the fixed asset turnover ratio, and the ratio is expressed as a numerical value.

What are fixed assets?  

Long-term physical assets that a company owns and uses in its operations to generate income are known as fixed assets. These consist of property (land and buildings), plant (factories and facilities), and equipment (tools and machinery). They represent significant investments for businesses, particularly in capital-intensive industries. Understanding fixed assets is crucial because they form the foundation of the fixed asset turnover ratio calculation.

Formula and calculation  

Fixed asset turnover ratio formula

The fixed asset turnover ratio formula follows as below:  

Fixed asset turnover = Annualised revenue / Fixed assets

Where:

• Annualised revenue: Refers to the revenue for the current period (which could be monthly, quarterly, or year-to-date), adjusted to reflect the revenue for a full year through an annualisation calculation.
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• Fixed assets: The ending balance - the value of net fixed assets at the end of the specific period being analysed.

How to calculate fixed asset turnover ratio

To calculate the fixed asset turnover ratio, you can follow these steps:

1. Determine the annualised revenue figure.
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2. Identify the ending balance of net fixed assets.
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3. Divide annualised revenue by fixed assets.

Example calculation:

Imagine a company reports:

• Net sales: $500,000
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• Ending net fixed assets: $300,000

To annualise the revenue (since this is for a quarterly period):  

Annualised revenue: $500,000 × 4 = $2,000,000  

Now, calculate the fixed asset turnover ratio with the formula:

Fixed asset turnover ratio: $2,000,000 / $300,000 = 6.67

This indicates the company generates $6.67 in sales for every $1 invested in fixed assets.

Fixed asset turnover ratio analysis and interpretation  

The FAT ratio provides a valuable look into a company's operations. When the ratio is high, it usually means the company is earning a lot of revenue compared to its fixed assets, which is a good sign of efficiency. In contrast, a low ratio might indicate that the company is not using its assets very effectively, possibly due to excess capacity or decline in sales.

How to interpret fixed asset turnover by industry?  

Interpreting the FAT ratio requires context as benchmarks vary widely across industries, and a good ratio in one sector might not be the same in another. For instance, a FAT ratio of 2.0 might be excellent for a manufacturing company but poor for another industry firm. Comparing your ratio with industry averages helps you see how your company measures up to your competitors.  

Indications of low / high fixed asset turnover ratio  

The FAT ratio can be a great diagnostic tool to see how effectively a company utilises its fixed assets. However, it's important to understand what the numbers really mean, as excessively high or low ratios can reveal a lot about a company's operational effectiveness, financial health, and potential for long-term success.

Let’s explore these in detail:

Low ratio  

A low FAT ratio suggests that the company is struggling to generate sufficient revenue from its fixed assets. This inefficiency could be caused by several reasons.

1. Underutilised equipment
   
   One common sign of a low FAT ratio is when equipment or other fixed assets are not being used to their full potential. This scenario is especially concerning in industries requiring heavy capital investment, where fixed assets comprise a big part of the total investments.
   
   For example, a manufacturing company might invest heavily in advanced machinery but not run it at full capacity because of weak demand or poor planning. When assets sit idle or are not fully used, this can hurt revenue generation and pull down the FAT ratio.
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2. Overinvestment in fixed assets
   
   Companies might purchase more equipment, expand their facilities, or grow operations more than their sales volume can support. While these investments are often made with growth in mind, they can backfire if the expected increase in revenue doesn't happen.  
   
   For example, a retail chain might open too many stores without enough customer demand, which could lead to excess space and underperforming locations. This overcapacity causes the FAT ratio to fall, showing that the business isn't getting the most out of its fixed asset investments.
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3. Declining demand for products or services
   
   A low FAT ratio can also indicate that the market for a company's offerings is shrinking. When sales decrease but the fixed assets stay the same, the ratio drops naturally. This often happens during tough economic times, or when new competitors, changing consumer tastes, or industry disruptions come into play.
   
   For instance, a utility company might see its FAT ratio go down if energy-efficient technologies reduce electricity use. In this case, the low ratio suggests the company needs to rethink its strategy, maybe by offering new services.
   
   Implications of a low FAT ratio
   
   A consistently low FAT ratio can have serious consequences for a business:
   
   - Lower profits: Poor asset utilisation directly impacts the bottom line, as fixed assets represent sunk costs that must be covered by revenue.
   
   - Increased financial risk: Overinvestment in fixed assets can strain cash flow and increase debt if loans are used to finance the assets.
   
   - Missed growth opportunities: Underutilised assets tie up capital that could be used for other growth initiatives.
   
   To address a low FAT ratio, companies must identify the root cause and take corrective actions, like aligning fixed asset investments with actual demand.

High ratio  

A high FAT ratio usually means a company is making good use of its fixed assets, but understanding the reasons behind the high ratio value is important, as excessively high ratio can also indicate something entirely different.  

1. Efficient use of fixed assets
   
   A high FAT ratio often shows that a business is running efficiently. For example, a manufacturing company with modern, well-maintained machinery and improved production methods can generate higher revenue from its assets. In industries where fixed assets are critical to operations, a high FAT ratio demonstrates that the company is making the most out of their investments.
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2. Strong sales performance
   
   A high FAT ratio can also be a sign of good sales performance. Companies that excel at marketing, customer service, or product innovation might generate more than their fixed asset base.
   
   For instance, businesses operating in high-demand markets often see high ratios because sales grow faster than asset investments. This is common in sectors like e-commerce, where less capital is needed.
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3. Lean asset base
   
   Some companies keep things lean, relying on fewer assets to make revenue. For example, startups often don't need much infrastructure and would focus more on human capital. This makes their ratio naturally higher compared to capital-intensive industries.
   
   Older companies that have fully depreciated their assets might also show higher ratios since their net fixed assets are lower, even if they're still generating solid revenue. But keep in mind, a high FAT ratio doesn't always mean efficiency, as sometimes it just reflects older equipment.
   
   Potential risks of a high FAT ratio
   
   While a high FAT ratio is generally ideal, there are potential downsides to consider:
   
   - Overuse of outdated assets: Relying too much on outdated equipment might save money now but could lead to costly repairs or replacements later.
   
   - Underinvestment in growth: The company might not invest enough in new assets, which could impact future business growth.
   
   - Temporary market conditions: A high ratio may just be a temporary result of good market conditions or a sales spike. If these factors aren't sustainable, the ratio might drop when things return to normal.
   
   To keep a healthy FAT ratio, businesses must balance making good use of their assets with planning for long-term growth. This means regularly checking how assets perform, reinvesting in new technology, and aligning asset investment with overall business goals.

What is a good fixed asset turnover ratio?  

What's considered a ‘good’ ratio can vary, as it depends on the industry, the business you run, and how your operations are set up. Observing the trend over time can also indicate whether your assets are utilised efficiently or if there are any optimisation needs.  

Overall, a FAT ratio that's considered good should align with what's typical of your industry and reflect your company's ability to make the most of its fixed assets to generate returns. That's why reviewing this ratio regularly with the help of a business reporting software and comparing your data with your industry peers is essential, as it helps keep your business competitive and running smoothly.

Comparison  

Fixed asset turnover ratio versus asset turnover ratio  

While both ratios measure asset efficiency, they focus on different scopes. The fixed asset turnover ratio looks only on fixed assets like property, plant and equipment, making it useful for capital-intensive industries.

In contrast, the asset turnover ratio considers all assets, including things like inventory and cash, giving a broader picture of operational efficiency. Both metrics can be helpful and using thing them together can give you a more complete view of your company’s financial health.

Importance and limitations  

How useful is the fixed asset turnover ratio to investors?  

Investors rely on the FAT ratio to evaluate a company's ability to generate returns from its fixed assets. By comparing FAT ratios within an industry, investors can spot top-performing companies and make smarter investment choices.

For example, if one company consistently has a higher ratio than others, it may be better positioned for long-term growth. Adding this ratio to their analysis helps investors get a more comprehensive view of a company's potential for sustained success.

Limitations of the FAT ratio

Despite its usefulness, the FAT ratio has some notable limitations. For one, it doesn't account for differences in depreciation methods, which can make comparisons tricky. A company with older fully depreciated assets, for example, might appear more efficient than firms that have recently bought new equipment.

Plus, the ratio only shows how well assets are being used but doesn't show any insight into a company's profit margins or cash flow. However, when complemented with other financial metrics, it can offer a clearer understanding of overall operational efficiency and asset performance.

Final thoughts  

The fixed asset turnover ratio is a key metric for accounting professionals and financial analysts. It provides insight into how effectively a company utilises its fixed assets to generate revenue, helping stakeholders detect inefficiencies, identify opportunities and make data-driven decisions. Ultimately, the FAT ratio equips businesses with the ability to plan for growth and improve their operations, making it a powerful tool to ensure long-term financial success for your organisation.

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