Fixed asset turnover ration (FAT ratio) determines how much revenue is generated by entity for every dollar invested in non-current assets. In other words it measures how efficiently management is utilizing the capital investment to earn revenue.
Higher or increasing fixed asset turnover (FAT) indicates that entity is generating more revenue per dollar invested in fixed assets of the entity. In simple words higher FAT is desirable but it does not necessarily mean favourable in every situation.
Another closely related financial metric is Total Asset Turnover ratio that compares entity’s revenue over entire assets of entity.
Fixed asset turnover ration is calculated using the formula:
|Fixed Asset Turnover ratio =||Revenue|
|Average Fixed Assets|
In this formula:
- revenue can be gross or net revenue i.e. net of sales returns
- fixed assets can either be gross or net fixed assets i.e. net of accumulated depreciation.
In majority of situations, net figures are used to calculate FAT ratio.
This ratio needs information from income statement and statement of financial position. Income related figures are taken from income statement whereas for average total calculation, we need current and prior year’s total assets figure or in other words opening and cloing total assets. Formula for average total asset calculation is:
|Average total assets =||Total assets ending last year + Total assets ending current year|
Analysis and Interpretation
By directly comparing the periodic inflows generated from operating activities (technically called revenue) with capital outlay in terms of non-current assets that are used to carry out same operating activities, Fixed Asset Turnover (FAT) ratio measures the efficiency of entity’s asset in generating revenue. For investors it gives a basic idea how good company is doing with the investment already available to it.
Also considering the types of fixed asset controlled by the entity, investors can draw inferences about future cash inflows i.e. probable increase/decrease in revenue due to fixed assets’ nature and status and outflows i.e. if entity requires replacement of fixed assets and how entity is planning to do it.
FAT ratio yields higher result if any or both of the following occur:
- Net revenue increases
- Net fixed assets decrease
Higher or increasing FAT ratio indicates that entity is earning more revenue with same investment by:
- increasing market share
- introducing its products to new markets; or
- offering valued addition to customers either part of product (e.g. upgrades, innovation) in service to customers (e.g extending credit limits).
Lower or decreasing FAT ratio can be a result of:
- outdated products that customers are not willing to buy anymore and numbers are decreasing
- use of obsolete technology affecting production activity
- increased investment fixed assets that is not operating at full capacity yet or there are other bottlenecks that are limiting operational efficiency to improve. For example, workforce requires training, required type of raw material is not available.
Though fixed asset turnover ratio help understand entity’s ability to manage its fixed asset, it does have serious limitations and may give distorted results that may affect users’ decision making process. Some of them are discussed as follows:
- FAT ratio tend to increase even without the increase in revenue if entity is disposing off its assets. This may be the case if entity is facing financial turmoil or change in strategy by acquiring assets on operating lease or simply outsourcing the tasks or products that require such assets in which case they are not required anymore.
- Another factor that may render FAT unreliable is depreciation. If entity is using net fixed asset figure for ratio calculation, then with every passing year net fixed amount will decrease as result of additional depreciation. In such case even if revenue is constant, FAT ratio will appear to have improved.
- Even if entities have same investment in fixed assets, those using straight-line method of depreciation will tend to have better FAT ratio than those that use reducing balance method for depreciation calculation.
- FAT ratio is almost strictly industry-bound ratio i.e. if you have to entities from two different industries then comparing FAT ratios will not be much meaningful as each industry has different fixed asset requirement. In some cases, even if comparison is within the same industry, the way each entity is managed can have a bearing on FAT ratio. This is the case with internet based e-commerce entities that tend to have very limited investment in fixed assets and yet significant revenue generation.
- Another serious concern with FAT ratio is that fluctuations in revenue are hardly in perfect correlation. Entity can have a certain pattern for revenue but not necessarily a certain pattern for acquisition and disposal of fixed asset.
Although fixed asset turnover ratio gives an overall perspective of entity’s operational efficiency, change in FAT ratio also indicates the shift in the way business is being carried out. Decreasing FAT ratio may result if management decide to rely more on human capital instead of capital assets. For example an entity that used to make t-shirts at mass scale of few universal sizes and colors is now shifting to custom-stitch clothing.