Intermediate Financial Management (with Thomson One)

256 • Part 1 Fundamental Concepts
is in financial trouble, in which case MicroDrive may have a hard time ever collecting
the receivable. Therefore, if the trend in DSO over the past few years has
been rising, but the credit policy has not been changed, this would be strong evidence
that steps should be taken to expedite the collection of accounts receivable.
Evaluating Fixed Assets: The Fixed Assets Turnover Ratio
The fixed assets turnover ratio measures how effectively the firm uses its plant and
equipment. It is the ratio of sales to net fixed assets:
Sales
Fixed assets turnover ratio
Net fixed assets
Industry average 3.0 times
$3,000
3.0 times
$1,000
MicroDrive’s ratio of 3.0 times is equal to the industry average, indicating that the
firm is using its fixed assets about as intensively as are other firms in its industry.
Therefore, MicroDrive seems to have about the right amount of fixed assets in
relation to other firms.
A potential problem can exist when interpreting the fixed assets turnover
ratio. Recall from accounting that fixed assets reflect the historical costs of the
assets. Inflation has caused the value of many assets that were purchased in the
past to be seriously understated. Therefore, if we were comparing an old firm that
had acquired many of its fixed assets years ago at low prices with a new company
that had acquired its fixed assets only recently, we would probably find that the
old firm had the higher fixed assets turnover ratio. However, this would be more
reflective of the difficulty accountants have in dealing with inflation than of any
inefficiency on the part of the new firm. Financial analysts must recognize that
this problem exists and deal with it judgmentally.
Evaluating Total Assets: The Total Assets Turnover Ratio
The final asset management ratio, the total assets turnover ratio, measures the
turnover of all the firm’s assets; it is calculated by dividing sales by total assets:
Total assets turnover ratio
Sales
Total assets
Industry average 1.8 times
$3,000
1.5 times
$2,000
MicroDrive’s ratio is somewhat below the industry average, indicating that the
company is not generating a sufficient volume of business given its total asset
investment. Sales should be increased, some assets should be sold, or a combination
of these steps should be taken.