We penalise companies that generate sales which are either unusually high or low relative to their net fixed asset base compared to industry peers. We also penalise any unusually large movements in either direction. Net fixed asset turnover measures a company's ability to generate sales from its fixed assets. Companies in the same industry should have a similar relationship between net fixed assets and sales although there will be huge differences across different industries. For example, capital intensive industries (such as infrastructure) will have large fixed asset bases resulting in a high ratio in excess of 30x compared to asset light industries (such as IT) which will tend to have low ratios below 10x, as shown in Figure 23.
We are especially concerned about companies where net fixed asset turnover is extremely low relative to industry peers (i.e. a low level of sales relative to PPE). This might be acceptable in some industries, such as trading companies, but is unusual for the vast majority of industries. A low level of fixed assets can indicate that a company is actually producing very little, its sales are fake, or it’s acting as an agent rather than the manufacturer it portrays itself to be. It may also suggest that the company does not own or cannot prove ownership of its fixed assets, hence, it does not book them on its balance sheet. Small fixed assets can also mean small depreciation charges which flatters profits and may mean that the company has invested very little in tangible assets, despite growing sales or the need to replace worn out machinery.
Our accounting screen is set to trigger a red flag when fixed assets/sales is below the 20th percentile or above the 80th percentile relative to industry peers (i.e. it is too high or too low relative to peers). Red flags are also triggered by unusually large changes.
