Fixed Asset Turnover Ratio

What Is the Fixed Asset Turnover Ratio?

The fixed asset turnover ratio (FAT) is, in general, used by analysts to measure operating performance. This efficiency ratio compares net sales (income statement) to fixed assets (balance sheet) and measures a company's ability to generate net sales from its fixed-asset investments, namely property, plant, and equipment (PP&E).

The fixed asset balance is used as a net of accumulated depreciation. A higher fixed asset turnover ratio indicates that a company has effectively used investments in fixed assets to generate sales.

Understanding the Fixed Asset Turnover Ratio

The formula for the fixed asset turnover ratio is:

FAT = Net Sales Average Fixed Assets where: Net Sales = Gross sales, less returns, and allowances Average Fixed Assets = NABB − Ending Balance 2 NABB = Net fixed assets’ beginning balance \begin{aligned} &\text{FAT} = \frac { \text{Net Sales} }{ \text{Average Fixed Assets} } \\ &\textbf{where:} \\ &\text{Net Sales} = \text{Gross sales, less returns, and allowances} \\ &\text{Average Fixed Assets} = \frac { \text{NABB} - \text{Ending Balance} }{ 2 } \\ &\text{NABB} = \text{Net fixed assets' beginning balance} \\ \end{aligned} FAT=Average Fixed AssetsNet Saleswhere:Net Sales=Gross sales, less returns, and allowancesAverage Fixed Assets=2NABB−Ending BalanceNABB=Net fixed assets’ beginning balance

The ratio is commonly used as a metric in manufacturing industries that make substantial purchases of PP&E in order to increase output. When a company makes such significant purchases, wise investors closely monitor this ratio in subsequent years to see if the company's new fixed assets reward it with increased sales.

Overall, investments in fixed assets tend to represent the largest component of the company’s total assets. The FAT ratio, calculated annually, is constructed to reflect how efficiently a company, or more specifically, the company’s management team, has used these substantial assets to generate revenue for the firm.

Interpreting the Fixed Asset Turnover Ratio

A higher turnover ratio is indicative of greater efficiency in managing fixed-asset investments, but there is not an exact number or range that dictates whether a company has been efficient at generating revenue from such investments. For this reason, it is important for analysts and investors to compare a company’s most recent ratio to both its own historical ratios and ratio values from peer companies and/or average ratios for the company's industry as a whole.

Though the FAT ratio is of significant importance in certain industries, an investor or analyst must determine whether the company under study is in the appropriate sector or industry for the ratio to be calculated before attaching much weight to it.

Fixed assets vary drastically from one company type to the next. As an example, consider the difference between an Internet company and a manufacturing company. An Internet company, such as Facebook, has a significantly smaller fixed asset base than a manufacturing giant, such as Caterpillar. Clearly, in this example, Caterpillar’s fixed asset turnover ratio is of more relevance and should hold more weight than Facebook’s FAT ratio.

Difference Between the Fixed Asset Turnover Ratio and the Asset Turnover Ratio

The asset turnover ratio uses total assets instead of focusing only on fixed assets as done in the FAT ratio. Using total assets acts as an indicator of a number of management’s decisions on capital expenditures and other assets.

Limitations of Using the Fixed Asset Ratio

Companies with cyclical sales may have worse ratios in slow periods, so the ratio should be looked at during several different time periods. Additionally, management could be outsourcing production to reduce reliance on assets and improve its FAT ratio, while still struggling to maintain stable cash flows and other business fundamentals.

Companies with strong asset turnover ratios can still lose money because the amount of sales generated by fixed assets speak nothing of the company's ability to generate solid profits or healthy cash flow.