Asset Turnover Ratio: A Complete Guide for Investors

Asset turnover ratio represents the efficiency with which a company is able to use investments in its assets. It is defined as a ratio of sales and assets. Effectively, an asset turnover ratio intimates an investor the amount of sales that a company can generate from an investment of ₹1 in its assets.

A company with a high asset turnover indicates can generate a higher amount of sales from the same investment in its assets than a company with low asset turnover.

Asset turnover is also a representative of capital-intensiveness of the business of the company. It means that the companies with a low asset turnover would need to invest a higher amount of money in their assets to generate sales. Whereas the companies with a higher asset turnover would need to invest a lower amount of money in their assets to generate sales.

However, apart from a simple interpretation of the amount of investment needed to generate sales, an investor should focus on other secondary consequences of asset turnover (capital intensiveness). These secondary consequences primarily relate to the nature of competition that the company would face due to the ease or the difficulty of competitors to enter the business depending on the amount of capital needed to start and run the business.

Another important consequence of asset turnover is the continuous requirement by the business for additional capital for growth. This is an especially critical parameter for companies that have a low asset turnover and as a result, are highly capital intensive.

The current article is our attempt to share our learning from the analysis of hundreds of companies and understanding their businesses where we could correlate different aspects of their business with their asset turnover. During our analysis of companies, we could notice that when asset turnover is above a certain level, then the business becomes highly competitive. Moreover, if the asset turnover is lower, then the company faces the risk of entering a debt-trap and a possibility of bankruptcy.

Therefore, in the current article, we have tried to explain how asset turnover influences the dynamics of the business of the company along with its competitive intensity. We have attempted to provide real-life examples for each scenario so that readers may correlate these learnings with actual life situations.

Before we proceed further, let us first understand different types of asset turnover ratio that investors use to assess the efficiency of utilization of capital by companies.

Different types of asset turnover ratios

Investors use different asset turnover ratios to assess the efficiency of capital deployment by a company. Most common of these asset turnover ratios are:

• Total asset turnover ratio
• Fixed asset turnover ratio and
• Net fixed asset turnover ratio (NFAT)

We prefer to use Net Fixed Asset Turnover Ratio in our analysis because it indicates the usage pattern of operative productive assets like plants and machinery after factoring in the wear & tear (depreciation) and excludes assets held in form of investments in third parties, cash etc.

We calculate Net Fixed Asset Turnover Ratio (NFAT) as:

NFAT = Sales / Average of Net fixed assets at the start of the year and at the end of the year

In their analysis, an investor would come across companies having a wide range of net fixed asset turnover. She would find companies with net fixed asset turnover of less than one as well as the companies with net fixed asset turnover of more than 10.

A Net Fixed Assets Turnover Ratio of 1 indicates that every incremental investment of ₹1 by a company in its plants and machinery would increase its sales by ₹1.

However, in the current article, instead of focusing on the simple interpretation of the investment required to generate the sales, we would focus more on the other key influences that the net fixed asset turnover has on the business dynamics of the company.

Let us first discuss how net fixed asset turnover influences the competitive intensity of any company.

A) High Net Fixed Asset Turnover Ratio increases competition from unorganized sector:

In our analysis, we have noticed that companies that have a high net fixed asset turnover ratio (NFAT), especially with an NFAT of 4 or more suffer from high competition from the unorganized sector.

This is because the companies with a net fixed asset turnover ratio of 4 or more have very low capital requirements. Such businesses require a comparatively very low amount of money to start the business and in turn, can generate a significant amount of revenue from the small amount of capital.

In most of the cases, the product or service provided by such businesses with a low capital intensity (i.e. high NFAT) is technologically very simple i.e. the technology needed to make the products or provide the services is easily available at a cheaper price.

Therefore, in such businesses, a lot of entrepreneurs raise money from their families and friends and start the business and increase the competition for existing players. As most of the times, such businesses do not involve advanced technology, therefore, their customers can easily switch from one supplier to another. In such situations, the key parameter that influences a customer’s purchase decision is the price of the product/service and the manufacturers lose any negotiating/pricing power over the customers.

Therefore, in such high net fixed asset turnover businesses, all the companies start competing primarily on price resulting in price wars.

Let us see a few examples where companies with a high next fixed asset turnover ratio faced intense competition from the unorganized sector.

1) Fineotex Chemicals Ltd:

Fineotex Chemical Ltd is an Indian company manufacturing speciality chemicals primarily for the textile industry.

While analysing Fineotex Chemical Ltd, an investor notices that the company had a net fixed asset turnover ratio exceeding 5 in the last 10 years. In FY2012, the NFAT was about 12.

As discussed above, a high net fixed asset turnover of 5-12 indicates that the business of textile chemicals needs comparatively low investment in plant and machinery.

As a result, any person/entity with a small amount of effort can raise the capital and put up a competing manufacturing plant. An investor would appreciate that this may lead to intense competition for Fineotex Chemical Ltd from small scale & unorganized players. This is because many firms in the unorganized sector may be able to compete with it by investing a small amount of money in the textile chemical manufacturing set up.

In the case of the textile chemicals segment, Fineotex Chemical Ltd highlighted to its shareholders that the industry is highly fragmented with many small suppliers providing intense competition.

FY2013 annual report, page 11:

Due to uncontrolled competition from unorganized sector, the Company has decided to follow a wait and watch policy before committing the balance funds. It has purchased land but is going slow on the nature of expansion to pursue.

In FY2014, Fineotex Chemical Ltd highlighted to the shareholders that the company is facing competition from small scale and unorganized sector and as a result, the company is exploring diversification in other lines of businesses.

FY2014 annual report, page 16:

The industry is fragmented and has many players from tiny industries to large corporations.

The risk from the small scale and unorganized sector is real and the company is taking steps to diversify in other products as well as other fields.

Subsequently in FY2017, Fineotex Chemical Ltd described the state of the industry in its annual report, which highlighted that the textile chemicals industry is fragmented with many small players who compete primarily on price to supply mostly commoditized chemicals.

FY2017 annual report, page 22:

Fragmented industry structure with few scaled up Indian players: Most players operating in India are still small in scale. At the global level, however, there is significant level of concentration. Most segments in India witness a dominating presence of a few global leaders. This has implications on the competitiveness of Indian players..

Commoditisation: Several mature products in the sector have already been commoditised or are at risk of the same.

Similar products, little differentiation: A majority of the Indian players sell chemicals with little differentiation, thus competing largely on price.

In such fragmented industries, the customers have the option of choosing from many suppliers. Therefore, the customers have a higher negotiating power. As a result, suppliers are not able to pass on the increase in raw material costs to the customers. In turn, whenever the raw material prices increase, the suppliers take a hit on their profit margins.

Fineotex Chemical Ltd has highlighted in its various annual reports that it is exposed to the risk of an increase in raw material prices and other inflationary factors. In FY2012, when the company witnessed a sharp decline in its OPM, then it explained it to the shareholders.

FY2012 annual report, page 6:

Due to rising costs of the oil, depreciating Indian Rupee and their inflationary impact on other items, the input costs continued to rise in the year under review. This also led to severe strain on the margins.

In FY2014, the company disclosed to the shareholders that it is not able to pass on the full impact of the increase in prices of its raw materials to the customers.

FY2014 annual report, page 13:

There was a record fall in the Rupee value vis-a-vis the US dollar during the year resulting overall rise in input costs which could not be fully passed on to the customers.

Therefore, an investor would appreciate that due to intense competition from the unorganized sector, the players in the textile chemicals industry end up having a low negotiating/pricing power over their customers as the customer has an option to choose from many suppliers.

An investor may read our complete analysis of Fineotex Chemical Ltd in the following article: Analysis: Fineotex Chemical Ltd

Let us see the example of another company, which has suffered from the intense competition as a result of high net fixed asset turnover ratio.

2) Kokuyo Camlin Ltd:

Kokuyo Camlin Ltd is a leading manufacturer of stationery & related products owning brands Camel and Camlin. The company is now a subsidiary of Kokuyo Co. Ltd of Japan.

While analysing Kokuyo Camlin Ltd, an investor notices that the net fixed asset turnover ratio of the company has been in the range of 4-6 over the last 10 years.

As discussed above, a net fixed asset turnover ratio of 4 or more usually indicates that an entrepreneur does not need a lot of capital to start the business and run it. Therefore, such companies face a lot of competition from the unorganized sector leading to intense price wars and low negotiating/pricing power over the customers. Kokuyo Camlin Ltd faced the same in its business.

The credit rating agency, CRISIL in its May 2014 report for Kokuyo Camlin Ltd highlights this aspect of the business:

The stationery products market is highly commoditised and fragmented, with many unorganised players, leading to stiff competition.

The credit rating agency, CRISIL, in its report of Kokuyo Camlin Ltd in February 2019 pointed out the fact that the low-profit margins of the company lead to a situation where even a slight change in raw material costs affect the profitability in a big manner.

Susceptibility to intense competition and volatility in raw material price: Intense competition may continue to constrain scalability, pricing power, and profitability. Further, since cost of procuring the major raw material accounts for a bulk of the production expense, even a slight variation in price can drastically impact profitability.

Kokuyo Camlin Ltd also highlighted in its annual reports that it is facing intense competition from multiple players.

FY2011 annual report, page 19:

Competition in last few quarters have been severe. With now many players both Indian and International vying for a share in this market, the consumer has a great choice but is overall reducing the pricing power.

The company reported net losses in three years, FY2012, FY2013 and FY2014. The company lamented its inability to pass on costs to customers in FY2013.

FY2013 annual report, page 13:

The major contributory for this loss in the financial year under review were increase in Input material cost, manpower cost & overheads and our inability to pass on this increase fully to our customers.

In FY2017, the company disclosed that the competitive situation has worsened due to the decline in commodity prices. Kokuyo Camlin Ltd highlighted that due to low commodity prices:

• There was no possibility of an increase in the prices of its products.
• Manufacturers from the unorganized sector could import at a very low price. As a result, their profitability increased significantly. Therefore, many unorganized players started importing products under their own brands, which led to further competition to organized/branded manufacturers.
• As a result, the company had to reduce the prices of many of its products.

FY2017 annual report, page 4:

The Challenges: The Indian stationery market faced significant challenges during the year. One of the key factors that affected growth and profitability was the continued pressure on prices that started in December 2015. Low inflation throughout 2016 combined with lower commodity prices globally left little room for any price increase. Historically, the industry used to have a 4% – 5% price increase every year. But in 2016, prices had to be reduced in many categories. In other words, the only way to maintain growth was through volumes.

Another major challenge was the increasing competition in every category of the stationery market. Most players have expanded their presence into more categories to maintain growth. Due to global fall in commodity prices, the margin for small and unorganized players to import under their own brands became attractive which further ate into the share of organized players particularly for price elastic products.

Due to the ease of entry of players in the low capital intensive stationary market, it has become very difficult for players like Kokuyo Camlin Ltd to maintain their market share. Companies need to spend a lot of money on advertisement and sales promotions. However, many times, large advertisement budgets also do not lead to any meaningful return on investment because the customer is not willing to pay a high price for a product where she can easily use the product of any other supplier.

Kokuyo Camlin Ltd faced a similar situation when it had to spend a lot of money to promote its brands like Camel and Camlin. However, despite huge spending, the advertisements did not make any contribution to profits.

Since FY2010, in the next eight years (FY2011-2018), Kokuyo Camlin Ltd spent an amount of ₹160 cr on advertisement and sales promotions. However, if the investor notices the result of this expense of ₹160 cr on the profits of the company, then she realizes that in concrete profitability terms, there is no value addition.

In FY2010, the company had reported a net profit after tax of ₹12 cr. After spending additional ₹160 cr on advertisement and promotions over the next eight years (FY2011-18), the net result was that Kokuyo Camlin Ltd.’s profits had declined to ₹10 cr in FY2018.

Therefore, an investor notices that due to low-capital-intensiveness, the intense competition in the stationary market, the manufacturers have lost the pricing power over the customers.

An investor may read our complete analysis of Kokuyo Camlin Ltd in the following article: Analysis: Kokuyo Camlin Ltd

In the above discussion, we learnt about instances where a high net fixed asset turnover ratio led to intense competition, which hurt the business. Let us now look at the impacts that the exact opposite situation of a low net fixed asset turnover ratio may have on businesses.

B) Low Net Fixed Asset Turnover Ratio may lead to a debt trap:

Low net fixed asset turnover ratio represents situations where a company needs to invest a lot of money in the assets to generate its sales. These businesses are highly capital intensive. In most of the cases, they continue to require large additional investments if the company wishes to grow its business.

During our analysis, we have noticed that usually, the businesses with a net fixed asset turnover ratios of less than 1.50 are highly capital intensive. Such businesses, if not managed properly, have a high risk of leading to debt traps and in turn risk of bankruptcy.

Let us see real-life examples of companies suffering due to low net fixed asset turnover.

1) Century Textiles & Industries Ltd:

Century Textiles & Industries Ltd is a B.K. Birla group company currently involved in the production of paper and textiles products, and real estate activities. The company has recently sold its large cement division.

While analysing Century Textiles & Industries Ltd, an investor notices that over the last 10 years, the net fixed asset turnover ratio of the company has consistently below 1.6 and in the recent years, it has declined below 1.

Please note that from FY2018, the sales of the company have declined by about 50% because the company sold its cement division that used to contribute more than 50% of sales, to its group company, Ultratech Cement Ltd. As a result, for FY2018 and FY2019 is the sales (operating income) excludes the impact of discontinued operations (primarily cement division) whereas the net profit after tax (PAT) includes the profit of discontinued operations.

As per FY2019 annual report, page 129, the cement division (discontinued operations) had a profit of ₹129 cr in FY2018 and a profit of ₹222 cr in FY2019. The addition of this profit in PAT without the related revenue in the sales increases the net profit margin (NPM). This is the key reason that from FY2018 onwards, the company has shown substantially higher net profit margin.

Therefore, an investor would notice that the absolute level of asset turnover of Century Textiles & Industries Ltd is low in the range of 1.00 and the average net profit margin (NPM) for last 10 years is in the range of 4%.

Now, let us try to understand how a low net fixed asset turnover ratio combined with low profitability has serious implications for any company as a huge amount of incremental investment is needed to show future growth.

For example, let us assume that in the first year, such a company targets to achieve ₹1,000 cr. of additional sales.

• As per the NFAT of 1.00 then it would need to invest INR 1,000 cr. in fixed assets (1,000/1.00, because the fixed asset turnover ratio is 1.00).
• This ₹1,000 cr. of additional sales would provide additional net profits of ₹40 cr. (assuming average NPM of 4% over the last 10 years).
• If the company retains entire profits and invests in its operations, then this incremental investment of ₹40 cr. of entire profits would generate only ₹40 cr. of incremental sales in the second year (as the fixed asset turnover ratio is 1.00, 40*1.00=40).
• If the company wishes to grow sales by another ₹1,000 cr. in the second year as well, then it would have to generate ₹960 of sales (=1,000 – 40) by investing additional ₹960 cr. (=960/1.00 or can be calculated as ₹1,000 cr of total requirement – ₹40 cr. of net profits reinvested). This ₹960 cr. needs to come from either fresh equity infusion or debt.
• Please note that these calculations would give the same inference even if an investor assumes that the new capital investment in the first year will take about 3 years to reach full utilization and the company will plan a new capital expenditure only after about 3 years of last capacity addition.

Thus, we may see that with a low fixed asset turnover of 1.00 combined with a low net profit margin of 4% results in a situation where the company would have to keep on relying on additional sources of funds to maintain its growth. As a result, it does not come as a surprise to the investor that in the past, the debt of Century Textiles & Industries Ltd has increased from ₹3,112 cr in FY2011 to ₹5,700 cr in FY2017.

The credit rating agency, CRISIL, highlighted that Century Textiles & Industries Ltd is not able to generate a good return on its assets in its report for the company in February 2015:

Lack of commensurate returns on capex incurred and high working capital intensity in most of Century’s businesses has added to high debt levels.

CRISIL also highlighted that Century Textiles & Industries Ltd has primarily relied on debt to expand its business in its report for the company in September 2015:

…mainly because of debt-funded capital expenditure (capex) of Rs.60 billion incurred over the six years through 2014-15 to expand its cement, paper board, and real estate businesses.

Such high debt in business operations that have a low return on assets is a very risky situation for any business. As the business is not able to generate sufficient cash/return on their assets, then it faces difficulties to repay its debt.

In light of this understanding, it does not come as a surprise to the investor when she notices that from FY2018, Century Textiles & Industries Ltd started hiving off its assets to reduce debt. In FY2018, it leased out the rayon unit to Grasim Industries Ltd to receive about ₹900 cr to repay debt. However, ₹900 cr was not sufficient to bring the company out from the debt-trap.

The credit rating agency, CRISIL in its report for Century Textiles & Industries Ltd in February 2019 highlighted that the company does not have sufficient liquidity to repay its debt obligations in FY2019.

While the repayment obligations came down with debt reduction post Grasim transaction, the annual cash generation, is not expected to be sufficient to service the obligations in fiscal 2019.

Advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

With the current understanding of low return on investments done by taking huge debt, an investor would appreciate that the company was in a very tough position. As a result, it had to demerge its cement division to get rid of another about ₹3,000 cr debt.

When an investor sees the situation of Century Textiles & Industries Ltd concerning excessive debt taken to create cement, paper, textile assets, which are not giving sufficient return on investment. Moreover, the cash generation in FY2019 was not sufficient to meet debt obligations even after four years from the completion of last major capital expenditure (cement unit in Manikgarh, Maharashtra was completed in September 2014). Then she understands that Century Textiles & Industries Ltd was in a desperate situation to get out of debt trap.

With this background when an investor reads the conference call transcript held by the company in May 2018 to discuss the demerger of cement unit, then she is able to understand the urgency of the management to sell off the cement unit without waiting for an independent bidding process.

Conference call transcript, May 2018, page 4:

If we go for bidding it will take time and delay the growth of the real estate business. So to speed up the real estate development, we have expedited the process of cement outgo and this will help us ramp up the start our real estate activity.

Also read: How to do Business Analysis of Real Estate Companies

The company tried to speed up the sale of cement sales without going for a bidding process even though many minority shareholders clearly reminded the management that they are not happy with the valuation of the cement assets offered. The minority shareholders also reminded the management that it has a fiduciary duty towards the shareholders to get the best value for the cement assets and therefore, the company should go for bidding.

Conference call transcript, May 2018, page 5 (Dheeresh Pathak from Goldman Sachs):

So obviously the EBITDA multiple is not the right multiple as we have seen with cement. Once the asset is out for multiple players to bid, it fetches n higher value because people think of it as asset value rather than just EV/EBITDA multiple right now because the EBITDA is depressed. For most of the midcap or small cap names you can see EBITDA is depressed. So I would strongly recommend that is your Fiduciary duty also as management of the company to make sure that we get the best value for the asset because we as minority shareholders we are not happy with the valuation we have got so that is my humble request to you.

However, the company went ahead with the demerger of cement assets to Ultratech Cement Ltd without any bidding. In the voting on the proposal, about 18.61% of minority shareholders voted against the proposal (Source: Voting results submitted to BSE dated Oct. 25, 2018, page 11)

Therefore, an investor can understand that Century Textiles & Industries Ltd seemed to be under great pressure to sell off the cement division to get relieved of a major portion of the debt that it had accumulated to create assets, which were not producing any meaningful return for shareholders or to repay the debt. As a result, hiving off the assets in quick succession was the only solution and the company leased out rayon unit and demerged the cement division to group companies to get rid of about ₹3,800 cr of debt, which it could not service from its business cash flow.

Due to the sale and leasing out of assets, the total debt of the company declined from ₹4,359 cr in FY2018 to ₹1,400 cr in FY2020, a reduction of ₹2,959 cr.

The above case of Century Textiles & Industries Ltd is a good example for an investor to understand how a low net fixed asset turnover has led the company into a debt trap where it reached a situation in which it was unable to repay its lenders. As a result, the company had to sell its assets to reduce its debt.

An investor may read our complete analysis of Century Textiles & Industries Ltd in the following article: Analysis: Century Textiles & Industries Ltd

From the above discussions on the detrimental implications of both high net fixed asset turnover ratio as well as low net fixed asset turnover ratio on the companies, an investor may feel that she should avoid companies at either extreme of net fixed asset turnover i.e. with NFAT of less than 1.50 and an NFAT of more than 4. However, such a generalization may not be the right way of looking at potential investments.

An investor would appreciate the analysis of a business and a final investment decision is a combination of many factors that include financial, business, management and valuation analysis. Therefore, looking only at the net fixed asset turnover ratio to select or reject an investment may not be the best approach. An investor should do a comprehensive business analysis of the companies to make a final opinion.

Advised reading: How to do Business Analysis of a Company

Let us see examples of some of the companies that have done well despite having a high or a low net fixed asset turnover ratio.

C) High Net Fixed Asset Turnover Ratio should be associated with Intellectual Property:

When an investor looks at any company with a high net fixed asset turnover ratio, then she should always try to assess if the company has any intellectual property rights, patents, high technology, brand etc. that may protect it from the intense competition that might arise from unorganized sector.

Let us see examples of companies that have done well despite having a high net fixed asset turnover ratio as they could protect their business from the competition of unorganized sector due to intellectual property rights like technology and brands.

1) Hindustan Unilever Ltd:

Hindustan Unilever Ltd (HUL) is the largest FMCG (fast-moving consumer goods) company of India.

While analysing HUL, an investor notices that the company has a net fixed asset turnover ratio of 8 and above in the last 10 years (FY2011-2020). However, despite such low capital-intensive business, the company has grown its sales from ₹20,023 cr in FY2011 to ₹39,783 cr in FY2020 and has increased its operating profit margin from 13% in FY2011 to 25% in FY2020.

Such an improvement in the business with increasing sales, improving profit margins and no debt, despite having a high net fixed asset turnover ratio seems counterintuitive to an investor if she remembers the above discussion that a high NFAT indicates low capital needs and in turn, high competition from unorganized sector.

However, an investor would appreciate that HUL is enjoying such business performance with low capital investment needs because it has created strong barriers against the competition in the form of well-known and established brands in almost all its product segments. In addition, HUL has created a strong product distribution channel across the length and breadth of the country that makes its products available even in the remote areas.

As a result, HUL enjoys strong business performance despite low capital investment needs in the business i.e. high net fixed asset turnover.

HUL represents a case where a company could protect itself from the unorganized sector despite low capital investment needs (high net fixed asset turnover ratio) of the business by creating strong brands and distribution channel.

Now let us see examples where companies performed well despite low net fixed asset turnover ratio i.e. high capital investment needs of the business. Let us see how such companies avoided debt-trap despite high capital investment requirements.

D) Low Net Fixed Asset Turnover Ratio should be associated with high operating profit margins:

Whenever an investor analyses any company with a low net fixed asset turnover ratio i.e. a highly capital-intensive business, then she should always try to assess whether the high capital requirement is working as an entry barrier for the competitors leading to high-profit margins for the company.

An investor would appreciate that if any business has very high capital investment requirements, then the number of people willing to take the risk and make investments in that business would be lower. As a result, an existing company in such a business may face a lower threat of competition from new players and in turn, may enjoy high-profit margins. Thereafter, these high-profit margins may help the company earn higher cash flows that may take care of the high capital investment needs of the low net fixed asset turnover ratio business and the company may avoid the debt-trap.

Let us see an example of one such company that has stayed debt-free despite being in a highly capital intensive business with very low net fixed asset turnover ratio.

1) Wonderla Holidays Ltd

Wonderla Holidays Ltd is a leading player in the Indian amusement park industry with operational parks in the cities of Bangalore, Hyderabad and Cochin.

While analysing Wonderla Holidays Ltd, an investor notices that the business of the company highly capital-intensive as its net fixed asset turnover ratio is very low at 0.3. However, despite such a low net fixed asset turnover ratio, the company has been able to grow its business at a sales growth rate of 13% over the last 10 years from ₹90 cr in FY2011 to ₹271 cr in FY2020 and still, stay almost debt-free.

While assessing the profit margins of the company, an investor notices that Wonderla Holidays Ltd has been able to earn operating profit margins (OPM) in the range of 40% over the years. An investor would appreciate that an OPM of 40% for any business is a remarkable achievement. Whenever any business earns such high-profit margins, then it is natural that many other entrepreneurs would want to enter the business and earn high profits themselves.

However, when potential competitors look at the high capital investment needs of amusement park business and the existing brand created in the mind of the customers, then they refrain from competing in the same region as the existing amusement parks as there is a high risk of failure for the new amusement park. In addition, the existing amusement park can always drop the prices of the tickets to hurt the business of any new competitor who is yet to recover her investment.

As a result, an investor would notice that despite a low net fixed asset turnover (i.e. high capital intensive business), Wonderla Holidays Ltd has managed to stay debt-free because of high entry barriers for competition created by high capital investment needs of the amusement park business. The creation of a strong brand in the minds of consumers has also played a key role in this barrier to entry for new competitors.

An investor may read our complete analysis of Wonderla Holidays Ltd in the following article: Analysis: Wonderla Holidays Ltd

Therefore, whenever an investor comes across a company with a low net fixed asset turnover ratio, then she should try to find out if the high capital intensive nature of the business is acting as an entry barrier for new competitors. If yes, then she would notice that the existing players might earn a high-profit margin and in turn avoid debt-trap. However, if she notices that the high capital requirements are not acting as an entry barrier, then she would notice that the players would face debt-trap like the case of Century Textiles & Industries Ltd discussed earlier.

Summary

Net fixed asset turnover ratio is an important parameter that all the investors should analyse when they are assessing any company. It represents the amount of sales that a company can earn by investing ₹1 in its assets.

Ideally, a high net fixed asset turnover ratio is preferable over a low net fixed asset turnover ratio. This is because, the business with a high net fixed asset turnover ratio requires a low amount of capital for growth and in turn, can produce more free cash flow to return to the shareholders.

However, businesses with a high net fixed asset turnover ratio (i.e. 4 and above) tend to face intense competition from the unorganized sector because any entrepreneur can raise a small amount of money from family and friends and start a competing business. Such intense competition tends to reduce the pricing/negotiating power of the companies over their customers that leads to poor returns on investment. Nevertheless, if an investor finds a company that has high net fixed asset turnover ratio, which also has strong entry barriers for new competitors like established profitable brands, strong distribution network etc., then she would notice that such companies earn a high-profit margin and a respectable return on their investments.

On the contrary, when an investor analyses businesses with a low net fixed asset turnover ratio then she notices that such businesses have very high capital investment requirements. As a result, many times, in the quest for growth, such companies end up taking a lot of debt to grow their business. At times, the debt levels go out of control for the companies and they end up in a debt-trap where they have to sell their assets to repay the debt.

Therefore, whenever, an investor comes across any company with a low net fixed asset turnover ratio, then she should assess whether the company is able to use the high capital investment needs of the business as an entry barrier for new competitors by creating a strong brand in the minds of customers. This is because customer loyalty to the existing businesses in a high capital-intensive industry makes it very risky for new competitors to commit money for new ventures. As a result, the existing businesses may earn high-profit margins, which in turn may be sufficient to meet the high capital investment needs of the business and the company may remain debt-free despite being in a business with a low net fixed asset turnover ratio.

In addition, whenever an investor analyses the history of net fixed asset turnover (NFAT) ratio of any company over previous years, then she should focus on the trend of NFAT ratio. If she notices that the NFAT of the company is going down consistently, then she should do a deeper analysis to find out the reasons for the same. It might be a sign where the company is losing the efficiency of usage of its fixed assets.

However, she should keep in her mind that whenever any company starts a new manufacturing plant, then the new plant usually takes some time to reach optimal utilization levels. Many times, this period may range from 2-3 years. During this period, the company would tend to have a lower net fixed asset turnover ratio. Once the new plant reaches optimal capacity utilization levels, then the NFAT ratio would also tend to reach the historical levels.

Now, we have come to the end of this article where we have summarized our learning about net fixed asset turnover ratio after analyzing hundreds of companies. We believe that if an investor keeps the above observations in her mind while analysing the net fixed asset turnover ratio of any company, then she would be able to make good interpretations that would help her in her analysis and investment decision.

Do you use the asset turnover ratio when you analyse companies? How do you interpret this ratio? Have you felt that the asset turnover ratio helps in differentiating good businesses from poor ones? It would be great if you share your experience in the comments below. It would be very helpful for us as well as the readers.

Regards,

Dr Vijay Malik

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.