This is a detailed guide on how to calculate Fixed Assets to Net Worth Ratio with in-depth interpretation, example, and analysis. You will learn how to use its formula to evaluate a firm's ability to pay off its long-term debt.
Definition - What is Fixed Assets to Net Worth Ratio?
The fixed assets to net worth ratio, also referred to as the non-current assets to net worth ratio, is a simple calculation that tells us more about the solvency of a company.
It indicates the proportion of the company’s fixed assets which are currently frozen or can’t be used for meeting its debt obligations.
Using this ratio, you can easily find out the extent to which the firm’s assets are illiquid.
To understand the importance of this ratio, you need to first understand what fixed assets are.
Fixed asset is any asset that is not expected to be converted into cash in under 1 year.
Buildings, furniture, machinery, delivery trucks, etc. are some good examples of a company’s fixed assets. Details of fixed assets can be found under the Assets section of the balance sheet.
Having a lower ratio is favorable because this shows that the company you’re considering investing in does not rely too heavily on its fixed assets to meet its current debt obligations.
Conversely, a higher ratio may be a red flag as it indicates that the company’s solvency becomes lower since more funds are tied up with non-current and less-liquid assets.
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Formula
The formula for calculating a company’s net fixed assets to net worth ratio looks like this:
Fixed-Assets to Net Worth Ratio = Net Fixed Assets / Tangible Net Worth
To calculate net fixed assets, you will take the value of total fixed assets and deduct the accumulated depreciation from it.
Net Fixed Assets = Total Fixed Assets - Accumulated Depreciation
The net worth of the firm is what will be left if the firm decides to shut shop and pay off all its liabilities.
It’s worth noting that we do not include intangible assets while calculating total assets in the net worth calculation.
That’s because, even though intangible assets are still assets, but they are in physical in nature, or in other words, they cannot be seen or tough, as well as they are not easily converted into cash.
So instead of using the regular net worth of a company in your valuation, you can go ahead and exclude the intangible assets from that company’s total net worth like so:
Tangible Net Worth = Total assets - Total Liabilities - Intangible Assets
These figures are all reported on a company’s balance sheet.
Example
In order to help you understand clearly how to find this ratio, let’s consider a quick example.
For example, you can investing in Company MM that has $650,000 in fixed assets. The firm claimed $85,000 in depreciation on the machinery in each of the last two years.
After looking into its financial statements, you found that it has $600,000 in total assets, $65,000 in intangible assets, and $125,000 in total liabilities.
So how do we find this company’s fixed-assets to net worth ratio?
First of all, you will need to calculate its net fixed assets, like so:
Then, you can find the company’s tangible net worth by subtracting the intangible assets and total liabilities from its total assets, like this:
By using the given formula, you can easily arrive at Company MM’s net fixed assets to tangible net worth ratio of 1.17, as follows:
The ratio value of 1.17 indicates that the company’s net fixed assets value is outweighing its tangible net worth.
That’s to say, this company relies too much on low liquid assets, and it may face difficulty when converting these assets into cash when needed.
Interpretation & Analysis
A value higher than 0.75 (optimal ratio may vary depending on the industry and the specific circumstances in which the firm is operating) signifies that the firm in investing excessively in non-liquid assets.
It could mean that there is too little cash left for day to day operations of the firm.
A firm having such a high ratio might not be prepared to handle any unexpected events that affect their business.
A high value could also mean that the firm is not able to efficiently utilize its fixed assets.
Higher the proportion of assets that are illiquid, lesser the amount available for company’s other operations and working capital.
So what is a good fixed assets to net worth ratio?
In short, the lower, the better. Ideally, you should look for companies with the fixed assets to net worth ratio of 0.50 or lower.
As mentioned earlier, there’s no standard value for this ratio. However, as an investor, you had better avoid investing in less liquid companies.
It’s worth spending some time comparing the net fixed assets to total net worth ratio of a company with that of its competitors and the industry averages.
By doing so, you can easily determine how your company’s utilizing its fixed assets, thereby you can make a better investment decision.
Cautions & Further Explanation
It should be noted that the fixed-assets to total net worth ratio should neither be very high nor very low.
Too high a value indicates low solvency level and too low a value indicates that the firm has insufficient fixed assets for continued operations.
You have to be careful while calculating the net worth of a firm.
Intangible assets such as goodwill and intellectual property are not counted in the total asset calculation.
It is very difficult to assign a value to intangible assets and thus lenders usually care only about the tangible assets.
Just like any other ratios, this ratio alone does not show a complete picture of the firm’s financial position.
Other ratios need to be looked at along with peer and industry ratios to reach meaningful conclusions.
