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Study Guide
Financial Ratios
Financial Ratios are an important tool that allows those inside and outside of a business to evaluate business performance in an objective fashion. Ratios can be used to assist in decision-making and goal setting for the business owner as well as to help identify symptoms of underlying problems and to measure progress over time. Lenders find ratios helpful in evaluating the business’ credit risk.
In the late 1980’s, The Farm Financial Standards Council (FFSC) was developed to look into the feasibility of standardized financial statements for producers to use when analyzing their business. Part of their mission was to identify measures of financial position and performance for farm and ranch businesses and to recommend the most accurate method of calculating each of those measures. They adopted 16 financial measures broken down into five critical areas:
- Liquidity
- Solvency
- Profitability
- Financial efficiency
- Repayment capacity
The Task Force recommended guidelines for calculating and interpreting each of the financial measures but did not establish numerical standards. Their recommendation was that farmers/ranchers use these measures to develop trends, and to compare results with other similar operations when that information is available. Farm Credit Services has established some benchmarks for their borrowers and presents them in terms of green, yellow, and red lights. These benchmarks will be included in the discussion below. A green light represents low risk, a yellow light indicates moderate risk, and a red light corresponds to high risk. A green light doesn’t guarantee success nor does a red light imply that the business will fail, as there are many issues that need to be taken into account in the analysis of any business. Talk with your lender about what benchmarks s/he uses to evaluate credit risk.
In the following section, each of the categories and the associated ratios will be explored. To help clarify the calculation of these ratios, we will use the information for an example farm found in Tables 1, 2 and 3 on pages 6 and 7 to calculate each ratio.
Liquidity —this is defined as measure of the ability of a farm business to generate sufficient cash to meet financial obligations as they come due in the next 12 months without disrupting or curtailing the normal operation of the business. The two financial measures for liquidity; current ratio and working capital are calculated from information found on the balance sheet:
Current Ratio = current farm assets ÷÷÷÷ current farm liabilities
This ratio is usually reported as a number compared to 1—i.e. 1.50:1. This is interpreted as “ for every $1 of current liabilities, the business has $1.50 in current assets available to cover these commitments.” If the ratio is 1:1 then there is just enough current assets to cover current liabilities but there is no safety margin for price changes and other factors. The larger the ratio, the more liquid the business. Farm Credit Services generally considers a ratio of greater than 1.50 to be a green light, between 1.00 and 1.50 a yellow light, and less than 1.00 a red light. There are several factors that can impact the interpretation of a current ratio. For example, a dairy operation can manage with a lower ratio due to low inventories and a steady monthly income. There will also be some variation in this ratio depending on the point in the production cycle. A business that is attempting to improve the current ratio should start by looking at their loan structure. If non-current assets were being financed with current debt (i.e. operating loan), this would have a negative impact on the current ratio. A second area to investigate would be to evaluate the marketing plan to better time cash inflows and outflows. The Current Ratio for our example farm at the end of the year‘X1 would be: $112,500 ÷ $88.860 = 1.27: i.e. the example farm has $1.27 of current assets to cover current liabilities.
Working Capital = current farm assets – current farm liabilities
If you were to convert all your current assets to cash and pay off all current liabilities, how much would you have left to continue operating? Working capital is the owner’s share of current assets and is reported as a dollar value, not a ratio. Because it is an absolute value, working capital is difficult to use when comparing the liquidity of businesses of different sizes. However, it can be used by the individual business to develop a trend. As working capital increases, the flexibility of the business in terms of marketing, purchasing equipment, and timing cash flows improves. Working capital should increase over time unless there are special circumstances such as an expansion of the business. The working capital for our example farm would be: $112,500 - $88,860 = $23,640.
Solvency —this addresses the relative relationship among assets, liabilities, and equity. Solvency is ultimately a measure of the business’s ability to repay all financial obligations if all assets are sold. It is also used to predict the ability to of the business to continue to operate after a financial setback. There are three ratios that the FFSC recommended and any of these ratios will, when correctly computed and analyzed, provide full information about solvency. The three financial measures for solvency; debt/asset ratio, equity/asset ratio, and debt/equity ratio are calculated from information found on the balance sheet: Debt/Asset Ratio = (total farm liabilities ÷÷÷÷ total farm assets) X 100
This ratio measures what part of total assets is owed to lenders and is expressed as a percentage. As this ratio increases, management flexibility decreases and earnings are more stressed to service debt. However, a very low debt/asset ratio may indicate that a manager is hesitant to use debt capital to take advantage of opportunities and thus is limiting his/her income potential. A ratio of less than 30% is considered a green light, 30-55% a yellow light, and greater than 55% a red light. Ideally, this ratio should
Rate of Return on Farm Assets (ROA) = (NFIFO + interest expense – owner withdrawals) X 100 average farm assets
This ratio analyzes how good of job the farm's assets-both capital and human-are doing in producing profit and is expressed as a percentage. Other terms used for this measure are return to capital or return on investment. It is obtained by dividing the dollars earned by both debt and equity capital by the average dollar value of assets held for the year. We start by adjusting net farm income from operations to account for borrowed money by adding back in the interest expense for the year. We then subtract the money the owner withdrew over the year to account for unpaid labor and management. To calculate the average total farm assets, take the total assets from the beginning balance sheet, add the total assets from the ending balance sheet and divide by 2. For a business that owns most of it’s assets (rather than renting), a ROA ratio of greater than 5% is considered to be a green light, 1-5% as a yellow light, and less than 1% as a red light. If the farm rents most of the land it farms or a significant amount of the machinery and equipment, the ROA ratios would need to be higher for the business to remain competitive. Our example farm’s ROA is: [($46,800 + $29,500 – $36,000) ÷ $725,750] x 100 = 5.55%
Rate of Return on Farm Equity (ROE) = (NFIFO – owner withdrawals) X 100 average farm equity
This ratio measures how well the owner’s investment in the business is generating income. Again we adjust the net farm income from operations by subtracting the amount the owner has withdrawn from the business. Average farm equity is calculated by adding the business equity figures from the beginning and ending balance sheets and dividing by
- Because owner’s equity levels can vary widely, there are no benchmarks for analyzing ROE. The producer should monitor the trends in this ratio over time. This figure can be compared to the expected return on investments from non-farm investments (such as mutual funds, the stock market, etc.) with comparable risks to decide if the operation’s ROE is adequate. The ROE for the example farm is: [($46,800 - $36,000) ÷ $361,320] x 100 = 2.99%
Operating Profit Margin Ratio = (NFIFO + interest expense – owner withdrawals) X 100 gross revenue
This ratio looks at profits as a percent of total revenue generated. Interest expense is added back in to the net farm income from operations to eliminate the effect of debt on operating profit. This allows the operating profit margin ratio to focus strictly on the profit made from production without considering the debt level, which can vary considerably from farm to farm. By subtracting owner withdrawals, the results can be compared to other businesses where labor and management is hired. A ratio of 25% or greater is considered a green light, 10-25% a yellow light, and less than 10% a red light. The example farm’s Operating Profit Margin Ratio is: [($46,800 + $29,500 - $36,000) ÷ $200,400] x 100 = 20.1%
Financial Efficiency (Economic Efficiency) —this is a measure of the intensity with which a business uses its assets to generate gross revenues and the effectiveness of
production, purchasing, pricing, financing, and marketing decisions. The ratios associated with this are operating expense ratio, interest expense ratio, depreciation expense ratio, asset turnover ratio, and the net income from operations ratio. The information for calculating these ratios comes from the income statement. Strategies to increase financial efficiency include:
- Monitoring and reducing production costs where possible and prudent
- Increasing the quality, amount and value of production
- Improving the marketing of production
- Keeping owner’s withdrawals to a minimum
- Making sure that debt is properly structured
Operating Expense Ratio = total expenses – (interest + depreciation) X 100 Gross revenue
This is the key ratio used to measure financial efficiency. The operating expense ratio answers the question, “How much does it cost to generate $1.00 of revenue?” It is calculated by dividing total operating expenses (excluding interest and depreciation) by gross revenue. A ratio of less than 65% is a green light, 65-80% a yellow light and greater than 80% of a red light. A higher ratio is acceptable if a large portion of the farm/ranch is rented or leased. Very large operations such as nurseries or feedlots typically can survive with higher ratios because they have large volume and small margins. Regardless of size, decreasing margins indicate increasing risk. To lower the ratio, the producer should focus on reducing the five largest expenses (usually cropping, feed, labor, interest, and repairs), reducing owner withdrawals, and restructuring debt. The example farm’s operating expense ratio is: {[$153,600 – ($29,500 + $8,200)] ÷ $200,400} x 100 = 58%
Interest Expense Ratio = (interest expense ÷÷÷÷ gross revenue) X 100
This ratio measures the percentage cost of debt to the operation. It is calculated by dividing interest expense by gross revenue. If this ratio is high, it may indicate too much borrowed capital or a high interest rate on debt. Ratios that are less than 12% are a green light, from 12-20% a yellow light, and greater than 20% a red light. For the example farm the interest expense ratio is: ($29,500 ÷ $200,400) x 100 = 15%
Depreciation Expense Ratio = (depreciation expense ÷÷÷÷ gross revenue) X 100
This ratio measures the percentage cost of all depreciable assets such as machinery, breeding livestock, etc. It is calculated by dividing depreciation expense by gross revenue. Those operations with a large investment in newer machinery and equipment will have higher depreciation expense ratios. Because of the diversity of farming operations and levels of equipment, it is not possible to set any benchmarks for this ratio. The depreciation expense ratio for the example farm is: ($8,200 ÷ $200,400) x 100 = 4%
Asset Turnover Ratio = (gross revenue ÷÷÷÷ average total farm assets) X 100
Finally, an evaluation of how dependent the business is on support payments can be made by comparing total government payments to the margin. Because this is an absolute number, no benchmarks are available.
Table 1: Example Farm Balance Sheets
Summary of Balance sheet for example farm, 12/31/X
Current Assets = $101,000 Current Liabilities = $95, Non-current Assets = $609,000 Non-current Liabilities = $265, Total Liabilities = $360, Owner Equity = $350, Total Assets = $710,000 Total Liabilities & Equity = $710,
Summary of Balance sheet for example farm, 12/31/X
Current Assets = $112,500 Accounts Payable = $6, Notes & term debt = $24, Other current liab. = $58, Total current liabilities = $88, Non-current Assets = $629,000 Non-current Liabilities = $280, Total Liabilities = $368, Owner Equity = $372, Total Assets = $741,500 Total Liabilities & Equity = $741,
Table 2: Statement of Owner Equity 12/31/X
Owner equity 12/31/X0 $350, Net farm income for year ‘X0 $47, Less adjustment for income tax (8,150) Net after-tax income 39, Less increase in current portion deferred tax (2,600) Owner withdrawals from farm business (36,000) Nonfarm income contributed to farm business 9, Net owner withdrawals from farm business (26,500) Other capital contributions to farm business 0 Other capital distributions from farm business 0 Increase in market value of farm assets 19, Less increase in noncurrent deferred taxes (8,000) Net increase in valuation equity 11, Owner equity, 12/31/X1 $372,
Revenue:
- Table 3: Income Statement for example farm for year ending 12/31/X
- Cash sales 202,
- Government program payments 3, Inventory changes (6,300)
- Change in accounts receivable 1,
- Other farm income - Total Gross Revenue 200,
- Purchased feed & grain 12, Expenses:
- Purchased market livestock 28,
- Other cash operating expenses 73, - Accounts payable 1, Adjustments: - Prepaid expenses 1, - Accrued expenses
- Depreciation 8, - Total Operating Expenses 124,
- Cash interest paid 30, - Total Interest Expense 29, Change in interest payable (500) - Total Expenses 153,
- Net Farm Income From Operations (NFIFO) 46,
- Gain/loss on sale of capital assets 1,
- Net Farm Income 47,
