* Shipping (ships, trains, trucking)
* Site Developers
* Crane Operations
* Marinas and Marine Construction
* Real Estate Rentals
* Transportation ( haulers, taxicabs, ferries, cruise ships)
* Golf Courses
* Mining and Drilling (oil, water, natural gas)
As with other activity ratios, the higher the value the more leverage is exercised and the more likely the ratio indicates success. To understand this particular ratio, this chapter will first cover the two elements that make up the ratio’s formula. Next, it will further clarify its concept then its application in business. Along the way, this chapter will identify flaws and misapplication. Once completed, the reader will be well versed in its proper interpretation and use with business.
Fixed Asset Turnover Rate Formula
The textbook formula is:
In reality, the formula must be more refined in order to get any real discernible information or value from the results. Many businesses break the company’s revenue into function sources for the respective sales. For example there is a big difference between a sale generated as a function of inventory (inventory turnover rate) and a sale as a result of using equipment. To illustrate, this electrician separates his sales via departmental accounting based on inventory, service and equipment.
. S & B ELECTRIC
. Departmental Revenue Statement (Limited Scope)
. For the Month Ending September 30, 2016
. Parts Service Equipment Total
Gross Sales $47,304 $207,647 $89,493 $344,444
Discounts (707) (2,980) -0- (3,687)
Adjusted Gross Sales 46,597 204,667 89,493 340,757
– Returns (207) -0- -0- (207)
– Allowances -0- (3,402) (1,600) (5,002)
Net Sales $46,390 $201,265 $87,893 335,548
Other Revenue 3,618
Total Revenue $339,166
His equipment department consists of two lift bucket trucks and a trencher generating sales from light pole maintenance and repairs along with setting underground wiring (trenching). He uses item tracking with his invoicing to separate out parts, service and equipment.
Notice in the above revenue report there are three lines of information related to sales: 1) gross, 2) adjusted and 3) net. The proper line to use with the fixed asset turnover rate formula (equation) is net sales related to equipment, i.e. $87,893.
If the reader uses any other sales data point, the formula’s design significantly impacts the resulting value. Take a look at this table for illustration assuming $100,000 of historical cost for the equipment.
. S & B ELECTRIC
. Fixed Asset Turnover Rate Results
. Various Sales Data Points
Data Point $Sales Value Fixed Asset Turnover Rate*
Gross Sales (All) $344,444 3.444:1
Gross Sales (Equipment) 89,493 .895:1
Adjusted Sales (All) 340,757 3.408:1
Net Sales (All) 335,548 3.355:1
Net Sales (Equipment) 87,893 .879:1
Total Revenue 339,166 3.392:1
* Assumes $100,000 of Costs for Equipment
So which answer is the best? The correct ratio is .879, net sales related to equipment only. The use of gross sales generates a higher ratio and although very close in value; the .016 difference does become significant if the equipment dollar value in the equation decreases. Try it; change the equipment dollar value to $70,000 and notice the difference.
It is important for the reader to understand why net sales is used as the numerator in activity ratios instead of gross or adjusted sales.
First off it is much more accurate.
Secondly, many industries have large percentage differences between total gross sales and net sales. For example, in residential construction, the adjustments for returns and allowances often approach 8 and 9% of contract values. In medicine, adjustments can reach as much as 48% on the dollar.
So it is essential to use the correct figure when calculating the fixed asset turnover rate or for that matter, any business ratio.
The concept of using the correct value also applies to the fixed asset value. Do you use cost basis, tax basis or historical costs?
Accountants use a weird concept called depreciation. This accounting principle allocates to expense the original cost of the fixed asset over the expected life of the asset. Therefore the cost basis (historical purchase price less depreciation) changes from one accounting period to the next. It wouldn’t make a difference between cost or historical basis purchase price with the formula contingent that: A) depreciation is fairly applied from one accounting cycle to the next and B) there is consistency in application for all fixed assets. The reality is that there are several different forms of depreciation (GAAP, accelerated, tax, and Section 179) used for individual and asset groups. In addition, no two companies use the same depreciation amounts each year. Furthermore, since cost basis is constantly decreasing from one period to the next, the resulting turn ratio is constantly increasing. Look at this example for S&B assuming depreciation of the fixed assets at 20% per year.
S&B Electric – Fixed Asset Turnover Rate (Yearly)
Sales Volume = $650,000 from equipment fees (invoices)
Year Cost Basis Formula Fixed Asset Turnover Rate
2013 $100,000 $650,000/$100,000 6.5:1
2014 80,000 $650,000/$80,000 8.125:1
2015 60,000 $650,000/$60,000 10.833:1
2016 40,000 $650,000/$40,000 16.25:1
2017 20,000 $650,000/$20,000 32.50:1
The results are more misinformative than valuable to the reader. The actual physical assets didn’t change; only the dollar value in the denominator changed. So the formula’s results in 2017 are 3 times better than 2015 with the same sales volume. The formula’s goal is to identify the ability of management to leverage (efficiently use) fixed assets. The higher the rate, the better the ability to leverage the asset(s).
So in reality, the better formula is as follows:
Fixed Asset Turnover Rate Analysis
The primary purpose of this formula is to evaluate the ability of management to utilize fixed assets to generate value via sales for the company. So let’s think about this concept for a moment. Only equipment intensive business operations should use this tool as other business sectors rely on other forms of assets to generate sales. Here is a list of industries and their corresponding assets that generate sales.
Industry Assets Explanation
Retail Inventory The retail industry’s sale is mostly tied to inventory to produce the corresponding transaction. Retail has low fixed dollar value of fixed assets as a percentage of total assets.
Professional Services None Knowledge exists within the professional staff. Although technology and software are essential, in the overall scheme of the sale, the customer is buying brain power and experience.
Services Labor Very similar to professional services, the customer is buying human muscle. Fixed assets have little to no value with sales.
Food Service Food/Labor Although a bit more equipment intensive than traditional services or retail, the fixed asset component of the transaction makes up only 20% of the value sold. Food and labor are the prime forces of the economic transaction.
Construction Materials Construction is mostly combining raw materials with the talent to build something. Fixed assets are used to expedite the process, but have very little bearing on the final price.
As industries shift towards a greater reliance on equipment to produce a product or render a service, the fixed asset turnover rate becomes an essential ratio for analysis. In general, as fixed assets tend towards more than 50% of the final sales price, the ratio becomes more important. Take a look at these industries.
Manufacturing – The equipment used to process or make the product are instrumental in determining the final sales price. For example, the manufacture of paper towels is more reliant on the various processes and equipment than the raw resource used to make paper towels. This is true with most non-food consumer goods.
Utilities – Imagine the historical cost basis to build the entire electrical power generation system and its corresponding electrical distribution system. The cost of the raw energy is a very low percentage of the net sales price to the consumer. This is also true with all utilities: water, sewage treatment, natural gas and so on.
Transportation – When most people think of trains, they envision a single locomotive pulling a few rail cars. The reality is starkly different. Not only is a locomotive pulling rail cars, it is pulling over 100 cars on a track that goes on for miles. There is real estate involved, engineering of the system, safety mechanisms, all with just one engineer operating the main engine. The fixed asset aspect of the shipping charge is well over 80% of the value priced in the fees to customers. This is true with cargo ships, terminals and airlines. It is somewhat less with traditional long haul trucking as the labor component picks up 25 to 40% of the value associated with the final cost to the customer.
Real Estate – This particular industry has a high reliance on fixed assets as the underlying cost driver for rents charged to the tenant. Granted other costs drive the rent including taxes, insurance and maintenance; but the actual building is the core element of the basis for rent charged.
The reader must understand that this ratio’s effectiveness increases as the particular business or department’s underlying value delivered to the customer is derived from fixed assets. As this value slips below 50% of the sales price, the ratio’s results become less reliable and meaningful. In reality, once the fixed assets deliver less than 25% of the overall value to the customer, the formula’s results are unreliable.
The reason for this is price volatility increases as the sales price is more dependent on labor and materials, customarily referred to as variable cost. Fixed asset intensive products or services are more fixed costs based in the product’s/service’s underlying cost structure
USE THE FIXED ASSET TURNOVER RATE WITH INDUSTRIES THAT DEPEND PREDOMINATELY ON FIXED ASSETS TO RENDER SERVICE OR MAKE PRODUCTS. THE UNDERLYING VALUE FROM FIXED ASSETS MUST EXCEED 50% OF THE TOTAL WORTH SOLD.
Application of the Fixed Asset Turnover Rate
As explained with other ratios, a good way to use this tool is to compare one financial period to another. The best way is to actually monitor the trend of the results over long periods of time and identify or create a standard to use for the company. Here is an illustration of how one company uses this ratio to monitor management’s performance.
Lawson Crane and Rigging
Mr. Lawson owns a crane operation and provides 2 and 3 man crews to lift and set in place items for customers. Most of his work comes from contractors. The crew consists of the crane operator and at least one rigger. His invoices separate the two charges (equipment and labor). He has three different cranes that have different weight capacities and arm reach. Altogether the historical cost basis for his three cranes is $798,000.
In 2016, he added another crane costing $241,000 to the fleet. The following are his net sales by year, fixed assets cost and his fixed asset turnover rate.
. LAWSON CRANE AND RIGGING
. Fixed Asset Turnover Rate Schedule
. Date of Report
Year Sales Fixed Assets $ Value F/A Turnover Rate
2011 $991,000 798,000 1.242:1
2012 $1,063,000 798,000 1.332:1
2013 $1,002,000 798,000 1.256:1
2014 $1,101,000 798,000 1.379:1
2015 $1,114,000 798,000 1.396:1
2016 $1,232,000 858,250* 1.435:1
*Lawson bought the crane on October 1, 2016; therefore Lawson is using the weighted average of the fixed assets dollar value as follows:
Asset Cost $241,000
Utility .25 (1/4 of a year)
Asset Value $60,250
Existing Assets 798,000
Total Weighted Avg. $858,250
Lawson knows that in 2013 his turnover rate decreased to 1.256:1. He explains that one of his cranes was out of service for a period of two months for an engine overhaul.
This brings to light another aspect of the value of the fixed asset turnover. It can also identify asset uptime. Uptime is referred to by a different name in different industries.
A) Occupancy Rate – real estate rental including hotels, motels, apartments and resorts
B) Capacity – maximum, optimum and minimum operational parameters in manufacturing
C) Transit (Miles) – shipping, trucking
D) Utility – catch-all term for just about any industry
So the turnover rate actually evaluates two significant aspects of business.
First, the ratio is used to identify leverage or the ability to increase earnings from the use of the fixed asset(s). Going back to the fixed asset turnover rate schedule used by Lawson, each year saw progressing sales on the same cost factor. With detail analysis, sales are first adjusted for inflation and then used in the formula. The idea is to eliminate outside influences to get a value that reflects the ability of management to earn money from the fixed asset(s).
Secondly, the ratio can identify the overall utilization factor of fixed assets.
Management can improve ratios by selling off poor performing assets and replacing with higher performing (more efficient) or gain leverage with more modern assets. This utility factor should be measured with other monitoring methods such as hours of operation, through-put schedules and/or production flow records.
Naturally, there are drawbacks to this formula. In the overall scheme of business this ratio can be manipulated if used for comparison purposes between two similar businesses. For example, one business may purchase used equipment to perform work whereas the other buys only new equipment. Both dispose of equipment or fixed assets once the utility decreases to a certain performance level. Since the business with used equipment has a lower overall fixed asset dollar value, its ratio will naturally be higher. The risk of used equipment is the potential for higher downtime reducing overall sales from fixed assets. So a user or reader of this ratio should read the notes to the financial statements in regards to the fixed assets cost and respective life schedules. Although the ratio is higher for this business with used equipment, it doesn’t mean the business operation is better; it may mean it is riskier.
Another flaw comes into play with leased assets. Currently GAAP doesn’t require leased assets to be recorded as a fixed asset on the books of record. Therefore leased assets generate sales yet have a zero value in the denominator driving the formula higher. So readers should take this into consideration when applying the formula.
Businesses take invested capital (stock, retained earnings and long-term debt) and buy assets. Assets are used to generate sales. Inventory is used in retail, fixed assets are used with larger value sales transactions. The fixed asset turnover rate is designed to measure the efficiency in leveraging and maximizing utility from the fixed assets.
Overall, this activity ratio is limited in its informative capacity. It should only be used with evaluating very equipment intensive operations such as manufacturing, shipping and real estate holdings. Marginal equipment operations such as transportation and site development can use this ratio if properly applied (item tracking of sales or using departmental accounting). But the reality is that the value becomes blurred and potentially defective if the associated underlying costs of the associated sale are reliant on fixed assets for less than 50% of the total sale. Sophisticated business entrepreneurs never use this ratio for retail, service or food service operations.
Make sure the financial statements incorporate the value of leased assets in the overall fixed assets dollar value (found in the notes to financial statements) when determining the fixed asset’s historical cost.
As stated in other chapters (articles), never use a business ratio in isolation to judge the value of any business or its underlying stock. Use a minimum of a dozen ratios spread across all groups of ratios. The more ratios incorporated in the analysis the more accurate the final picture of the business. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.
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