Fixed assets are keys to huge growth potential for a business. But they can also lock businesses into narrow loan terms without a good return on investment.
In this article, you’ll find out why fixed assets are important to your business and what kinds of effects they can have on your bottom line. You’ll also have a strong understanding of the asset lifecycle and how it interacts with your financial statements.
By the end, you should know how fixed assets can fit into the larger financial strategies you deploy to grow your business. Let’s get started.
What Is a Fixed Asset?
Fixed assets are long-term assets a company uses to produce goods and services and ultimately generate income. They have an expected lifespan exceeding one year and produce economic benefits to the company throughout their life cycle. Examples include:
- Office equipment
- Furniture and fixtures
- Leasehold improvements
- Tools and equipment
Are Fixed Assets Tangible Assets?
Fixed assets typically refer to tangible assets, like land, buildings, and equipment, which are listed under Property, Plant, and Equipment (PP&E) on a company’s balance sheet.
Because tangible assets wear out over time, you can depreciate their value. Depreciation is an accounting method used to track the gradual reduction of an asset’s value over time and is an important part of a business’s tax planning strategy.
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Intangible Fixed Assets
There are also intangible fixed assets, though these generally don’t appear on the balance sheet. These are non-physical assets that have long-term value and are used in business operations but may or may not be depreciable.
Examples of intangible fixed assets include:
- Brand names
- Software licenses
- Intellectual property
- Customer relationships
Both tangible and intangible assets can be classified as fixed assets as long as they meet the criteria of being long-term investments used in the production of goods or services and have a useful life of more than one year.
Are Fixed Assets Current or Long-Term Assets?
Because fixed assets are held by a company for longer than a year and are difficult to revert into cash, they’re classified as long-term assets. In other words, they are noncurrent assets.
You’ll find fixed assets listed under long-term assets on the balance sheet, though they can affect other financial statements as well (we’ll go over that a little later).
Current assets, also called short-term assets, are liquid assets, which means they can be more readily converted into cash. This includes cash and cash equivalents, money market accounts, inventory, accounts receivable, and financial securities.
Current assets are intended to keep day-to-day operations flowing smoothly, whereas long-term assets are usually used as part of long-term growth strategies.
What Types of Businesses Have Fixed Assets?
Fixed assets are more significant in industries that require a lot of upfront capital, like manufacturing, real estate, and mining.
But even in industries that require less capital, fixed assets are an important part of the business strategy.
Even a freelancer needs some equipment, a computer, for example. These assets help entrepreneurs of all types build their businesses.
Why Are Fixed Assets Crucial for Your Business?
While there are several benefits fixed assets can offer your business, their primary purpose is to drive the sales and growth of the company.
- Necessary to produce goods: Machinery and equipment are necessary to produce a business’s goods and services. Without these fixed assets, it would be impossible for a business to operate. And investments in better equipment can increase production or lower the cost of production, which also adds to a company’s bottom line.
- Increases a company’s value: Ownership of high-valued fixed assets contributes to the company’s overall valuation. A business’s valuation is important because it determines its worth in the market, which influences investment decisions, fundraising efforts, and potential mergers or acquisitions. It’s also a key indicator of its financial health and growth potential.
- Help with tax deductions: For businesses where the ratio of fixed assets to total assets is higher, fixed assets represent a significant portion of the business’s worth. And, for fixed assets that can be depreciated, the asset's depreciation contributes to healthier cash flow through tax deductions.
- Help a business get loans and make investments: Fixed assets can give businesses access to additional capital investments through collateralization. Collateralization is when an asset is used to back a loan. Companies can use the equity in equipment or real estate to open a revolving line of credit. They can then use the line of credit to invest in other parts of the business and improve their overall cash flow.
How Do Fixed Assets Work?
When you acquire a fixed asset, you can record the price paid for it plus any installation costs on the balance sheet.
That increases the valuation of your business. Over time, the valuation of the asset depreciates, and you can expense the depreciation of the asset in increments. This shows up on your income statement.
You must select a depreciation method to expense the asset and follow that method until the item is fully depreciated. Common options include:
- Straight line: The asset's cost is evenly allocated for each accounting period over its useful life.
- Units of production: The asset's cost is allocated based on its usage or output during each accounting period.
- Declining balance: The asset’s cost is allocated higher in the earlier years of an asset's life, gradually decreasing over time.
The IRS and GAAP provide guidance on how long an asset's useful life is. Refer to those guidelines and consider working with a certified accountant to ensure you’re using the most advantageous method for your business.
How Do You Calculate Straight-Line Depreciation on A Fixed Asset?
Straight-line depreciation is a popular method because it is simple and offers even, dependable depreciative value write-offs every year. Here’s how you do it:
- Determine the initial cost of the asset: This is the amount that the asset was originally purchased for.
- Estimate the salvage value of the asset: The salvage value is the estimated value of the asset at the end of its useful life. This value is often provided or can be estimated based on the type and usage of the asset.
- Determine the useful life of the asset: This is the number of years that the asset is expected to be used in the business. The useful life can be found in the tax code for certain types of assets, or it may be estimated based on the expected wear and tear of the asset.
- Calculate the depreciable amount: Subtract the salvage value from the initial cost of the asset: Depreciable Amount = Initial Cost − Salvage Value
- Calculate the annual depreciation expense: Divide the depreciable amount by the useful life of the asset: Annual Depreciation = Depreciable Amount / Useful Life
The result will give you the amount that the asset will depreciate each year over its useful life. You can then multiply the annual depreciation by the number of years to find the total depreciation over a specific period.
Here's an example to illustrate:
- Initial Cost: $10,000
- Salvage Value: $1,000
- Useful Life: 5 years
Depreciable Amount= Initial Cost−Salvage Value
Depreciable Amount = $10,000 − $1,000 = $9,000
Annual Depreciation = Depreciable Amount / Useful Life
Annual Depreciation = $9,000 / 5 = $1,800
So the straight-line depreciation expense would be $1,800 per year for five years.
Some assets become obsolete and cannot be sold for salvage. For these, you may be able to take an additional tax write-off but speak with your accountant first.
What Is the Fixed Asset Turnover Ratio, And How Do You Calculate It?
The fixed asset turnover ratio is a financial metric that assesses a company's ability to generate sales from its fixed assets. It's particularly useful for companies that rely heavily on physical assets in their operations, like manufacturing or construction companies.
It’s calculated by dividing net sales by the average fixed asset balance:
Fixed Asset Turnover Ratio = Net Sale / Average Fixed Asset
A fixed asset turnover ratio of 1.5x means that for every dollar invested in fixed assets, the company generates $1.50 in revenue.
A higher fixed asset turnover ratio indicates greater efficiency, as the company generates more revenue per dollar of long-term assets owned. In general, a higher asset turnover ratio is preferred, as it indicates a company is effectively using its assets to generate sales. But, the ideal ratio varies significantly between industries.
A strong asset turnover ratio is a great indicator of financial performance and is a useful way to attract new investors to your company.
Fixed Assets and Financial Statements
Fixed assets affect financial statements differently, depending on the asset’s life cycle stage. A few financial statements are particularly impacted by the asset’s life cycle, such as:
- Balance sheet: The balance sheet provides a snapshot of a company's assets, liabilities, and shareholder's equity at a specific point in time. Fixed assets are typically categorized under noncurrent assets on the balance sheet because they are long-term assets that the company expects to use for more than one year. They can include tangible assets such as property, plant, and equipment (often abbreviated as PP&E), as well as intangible assets with a long-term nature if they are classified as fixed. The asset’s value goes down as it depreciates until it’s completely removed from your balance sheet.
- Income statement: While fixed assets are not directly listed here, depreciation expenses related to fixed assets are reported on the income statement.
- Cash flow statement: Purchases or sales of fixed assets, such as property, plant, and equipment, appear in the investing activities section of the cash flow statement.
- Statement of changes in equity: Indirect effects on equity accounts might be reflected here due to changes in fixed assets. This includes impairment, which is when a fixed asset's market value falls below its recorded value on the balance sheet. An impairment charge is recorded to reduce the asset's book value to its fair market value. This can affect net income and, consequently, retained earnings, which is part of equity. Another thing that could happen is revaluation, which is adjusting the value of a fixed asset on the balance sheet to reflect its current market value. Revaluation can be upwards or downwards and leads to changes in the asset's recorded value.
- Notes to the financial statements: The notes may contain additional information about fixed assets, including details about depreciation methods, breakdown of different types of fixed assets, or information about leases.
Let’s look at the five stages of the asset life cycle and then examine how each stage is affected by or impacts a business’s financial statements.
Stages of the Fixed Asset Lifecycle
There are five stages in the lifecycle of a tangible fixed asset. As we’ve seen, assets affect different parts of a business’s financial records as it progresses through its lifecycle. Let’s go over each stage.
|How It Can Benefit Your Business
|How It Affects Cashflow
|Evaluating how to best acquire and use an asset based on the company’s current position.
|Can invest in assets that improve production, operational efficiency, or offer another competitive advantage.
|This stage does not directly influence your financial statements, though your financial position should influence how much you can send and what kind of asset you purchase.
|Buying, building, or otherwise acquiring the asset.
|Reduces cash flow due to cost of purchase. But increases the valuation of your business.
|There is an outflow of cash used to purchase the equipment. If you buy the equipment with a loan, the loan will appear as a line item under the liabilities sections of your financial statements. The liability will decrease over time as you pay off the loan.
|Consuming and depreciating
|Using the asset in the production of goods and services.
|Increases cash flow by enabling your business to make more sales and reduces your tax burden. Reduces asset value on your balance sheet.
|As the asset’s value decreases, the asset adds less value to your company’s overall valuation. Depreciation affects four financial statements: balance sheet, cash flow statement, income statement, and tax return.
|Operating, repairing, and maintaining
|Keeping up the asset during its useful life.
|Extending the useful lifetime of an asset with preventative maintenance.
|You’ll see cash outflows for energy consumption, repairs, and maintenance, while ideally seeing inflows from generating more sales.
|Selling, recycling, or otherwise discarding the asset.
|Can increase cash flow either through the sale of scrap or through additional tax deductions.
|If your business sells the asset for salvage, that will appear on your cash flow statement. You may also be able to donate it or depreciate that final amount for an additional write-off.
While every stage is important, planning has the largest potential ramifications. Fixed assets usually require a significant upfront investment.
It’s paramount to know the full scope of their costs—not just the purchase price but also the maintenance costs and expected lifetime. These costs must be measured against how well the asset retains value plus your expected return on investment (ROI).
As James Allen, CPA, CFP®, CFEI, puts it, “A fixed asset is not just a purchase; it's a long-term investment. So don't just ask how much it costs. Ask how much it can earn. Ask how it will help your business grow. Ask if it's the right tool for the job.”
You should also remember that asset management is just one part of a business’s strategy. Many other factors influence the ROI of your equipment and your long-term success.
What are the three categories of fixed assets?
The three categories of fixed assets are tangible assets (land, buildings, machinery, vehicles), intangible assets (patents, trademarks, copyrights), and financial fixed assets (stock, bonds, long-term loans).
What’s the difference between an asset and a fixed asset?
An asset refers to any item of value owned by a business, with total assets encompassing the entire range of assets. A fixed asset is one type of asset a company can control. Fixed assets are held long-term and are typically tangible (i.e., they can be physically touched). They’re also used for business operations.
How do fixed assets affect the balance sheet?
Your balance sheet shows the assets and liabilities owned by your business. When you initially purchase an asset, its value appears on the balance sheet. As the asset depreciates, so does its value on the balance sheet. Once the asset is fully depreciated and disposed of (typically sold for salvage), the asset is removed from the balance sheet.
Investing in Your Business’s Future
Fixed assets aren’t merely numbers on paper—they're a testament to a company's investment in its future, its strategy, and its commitment to long-term goals.
These assets, like buildings, machinery, and equipment, provide value year after year, helping businesses grow and thrive. Managing them wisely can lead to efficiency and success (and tax deductions!).
So, the next time you're diving into your company's financials, give a little extra thought to those fixed assets. They might just have an interesting story to tell.