Ratios and measurements in farm finance

Liquidity measurements deal with the upper part of the balance sheet — the relationship of the current assets to the current liabilities. By definition, liquidity is concerned with the ability of the farm business to generate sufficient cash flow for family living, taxes and debt payments. Current farm assets include cash and those items that you will convert into cash in the normal course of business, usually within one year.

Current farm liabilities include those items that need to be paid within one year. In simple terms, the current assets are needed to pay the current liabilities. Could we expect that one can repay $120,000 in current liabilities, if they have $200,000 of current assets available to convert to cash? It is pretty safe to say yes, and there would be a cushion of $80,000 remaining.

Current ratio and working capital

Two common liquidity measurements are the current ratio and working capital.

The current ratio is calculated by dividing the current assets by the current liabilities. Using the former example of $200,000 of current assets divided by the $120,000 of current liabilities, we calculate the current ratio to be 1.67. This really means is that for every dollar of current debt, there is $1.67 of current assets to pay it with. That should work.

Commonly accepted ranges

• Greater than 2.0 is strong

• 2.0 to 1.3 would fall in the caution range

• Less than 1.3 would be vulnerable

Our 1.67 current ratio in this example would be in the middle range.

Working capital is not a ratio but is a measurement of dollars. It is calculated by subtracting the total current liabilities from the total current assets.

In our example, we said that they have a cushion of $80,000 ($200,000 minus $120,000). That is their working capital. There is no standard acceptable dollar amount of working capital.

What’s adequate liquidity?

Look at your working capital figure and think in terms of adequacy. Is an estimate of your income taxes liability listed as a current liability on your balance sheet? (It is good to have it listed.) If not, you need working capital to cover that. Are your property taxes listed as a current liability? (It is good to have them listed.) If not, you need working capital to cover them, also.

How much family living must come from the farm? In some cases, all of it must. In other cases none of it has to. These help to define how adequate the working capital is.

Remember the definition of liquidity is the ability of the farm business to generate sufficient cash flow for family living, taxes and debt payment. If the bills pile up faster than they can be paid, or the operating loan has to be refinanced because it will not get paid off, liquidity is not sufficient.

Does that mean that you are broke? No! In fact you could be very wealthy, but just not “liquid” enough.

Would working capital of $80,000 be adequate for your farm? It may be, or it may not be.

Working capital to gross revenue

FINPACK software adds another measurement to determine the adequacy of working capital, by computing the working capital to gross revenue. By comparing the level of working capital to a farm’s annual gross income, it puts some perspective into the adequacy of working capital.

A farmer that has a working capital to gross income ratio of 8 percent will rely heavily on borrowed operating money, because they will run out of their own working capital early in the year.

A farmer that has a working capital to gross revenue of 26 percent will rely on borrowed money during the year, but not as heavily and not as soon.

Commonly accepted ranges

• Greater than 30 percent is strong

• 10 percent to 30 percent would fall in the caution range

• Less than 10 percent  would be vulnerable

Remember that your balance sheet is a snapshot of your financial condition on a given day. Each day your balance sheet will change as you conduct business, pay bills, harvest crops, etc. Many of the business actions that you conduct each day affect your current ratio and working capital.

If your actions decrease your current ratio, is that bad? Possibly, but maybe not. It depends on what it was before and what it will be afterwards. If your intended purchase will decrease your working capital, is that bad? Possibly, but maybe not. Again, it depends on how adequate it was before, and what it will be afterwards.

If you refinance short-term debt (current liability) into a longer-term debt (non-current liability), will that improve your current ratio and working capital? Yes and yes. Is that good? It will improve the numbers and ratios and make life more comfortable, at least for a while. However, this is a good time to look at the situation. What is the reason that this short- term debt is so large that it needs re-structuring?

• If it is due to an infrequent, explainable force (for example, “got hailed out, and insurance was inadequate” or “lost a lot of pigs due to disease that hopefully will not happen again”), but otherwise the operation has had sufficient net profits, then the refinancing should be beneficial in both the short-run and long-run.

• However, if this operating loan has been growing over the years because the profits have not been sufficient to provide the living, pay the taxes and service the debt, then this liquidity problem is just a symptom of another problem. To refinance without fixing the problem will give you temporary relief, but it is not the long-term cure.

  • Now, you have a new longer-term loan that has a new annual payment (principal portion of term debt is a current liability) that you did not have before. If the payments in the past were excessive, they will be just that much heavier now. Yes, the old ugly, growing, operating loan is gone, but it will return.

Solvency, by definition, is the ability to pay off all debts if the business were liquidated. Solvency ratios deal with the relationship of the total assets, the total liabilities and the net worth. Three standard solvency ratios are: debt to asset ratio, equity to asset ratio and debt to equity ratio. Each ratio is listed as a percentage.

Debt to asset ratio

The debt to asset ratio is calculated by dividing the total debt by the total assets. A figure of 44 percent would mean that the debt equals 44 percent of the assets. Another way of saying this is that for every $1 of assets that you have, you have 44 cents worth of debt.

Commonly accepted ranges

• Less than 30 percent is strong

• 60 percent to 30 percent falls in the caution range

• Greater than 60 percent would be vulnerable

Equity to asset ratio

The equity to asset ratio is calculated by dividing the total equity by the total assets. A figure of 56 percent would mean that your equity (net worth) equals 56 percent of the assets. Another way of saying this is that for every $1 of assets that you have, you are contributing 56 cents of it, in the form of your net worth.

When you add the debt to asset ratio percentage to the equity to asset ratio percentage, they will always equal 100 percent. By looking at these ratios together, you could verbalize and say “of all the assets that I control, my creditors are furnishing 44 percent of the capital (debt) and I am furnishing 56 percent of the capital (equity).”

Debt to equity ratio

The debt to equity ratio is calculated by dividing the total debt by the total equity. This ratio is sometimes called the leverage ratio, because it looks at how your equity capital is leveraged by using debt capital. It compares the relationship of the amount of debt to the amount of equity (net worth).

This debt to equity ratio is more sensitive than the debt to asset ratio and the equity to asset ratio in that it jumps (or drops) in bigger increments than the other two do given the same change in assets and debt. The balance sheet that gave us the 44 percent debt and 56 percent equity ratios would calculate out to a debt to equity ratio .79. It is saying that for every $1 of net worth you have, there is 78.6 cents of debt.

Ratios calculated on cost and market values

The FINPACK balance sheet shows these solvency ratios listed in two columns: cost and market. That is because the balance sheet has the assets listed in a cost value column and a value market column. The ratios have been calculated on each. Since the cost column has the assets listed as “cost, plus improvements less depreciation,” the dollars of value on machinery, breeding stock, land, etc., may not resemble their true value. For that reason you would focus mainly on the solvency ratios in the market column.

Deferred tax liability

The FINPACK balance sheet also calculates deferred tax liability and lists it along with the other debts. Because of that, it produces two sets of solvency ratios: with deferred liabilities and excluding deferred liabilities. The ratios that exclude deferred liabilities may be the most meaningful.

Understand your debt

Having debt allows you to control more assets than you would if your capital (equity) was financing all of the assets.

Understanding this concept could lead the uninformed person to believe that the more debt you have, the more assets you control, and the bigger and better things will be. The informed person, however, understands that renting someone else’s money comes at a cost, just as renting someone else’s land comes at a cost.

In the case of renting money, the rent is called “interest.” There are times when the rent is fairly reasonable. There have been times in the past, and likely the future, when the rental cost of money is extremely high. This leaves the individual that has a lot of debt (highly leveraged) quite vulnerable to any interest rate changes -- the reason you want to lock low rates in for a long time, if you can.

It is important for you to know your debt to asset ratio. It is equally important to look at the trends of what it has been doing over years.

Just as your business actions affect your liquidity daily, they also affect your solvency. The same examples that we looked at when discussing liquidity are listed here, along with their effects on your net worth, and your debt to asset ratio:

In these examples, net worth is pretty stubborn. It does not change as you buy or sell assets. It increases when you make more profit than you spend for consumption and income taxes, and it decreases when profits are insufficient. Net worth changes if the value of your assets change. It increases if assets are inherited or gained by a gift. It decreases if assets disappear.

The debt to asset ratio increases when assets are purchased with borrowed money and decreases when assets are sold and the debt is repaid. If solvency is a problem, fixing it usually requires the sale of assets and repayment of debt. These decisions should come after careful analysis. Many come with tax ramifications.

Measures of profitability are: net farm income, rate of return on farm assets, rate of return on farm equity, operating profit margin and earnings before interest taxes depreciation and amortization (EBITDA).

Net farm income

Net farm income is your measurement of farm profits.

In the FINPACK analysis, there is a cost measurement and a market measurement. The net farm income figure in the cost column is the figure (profit or loss) generated by the accrual adjusted income statement. The figure in the market column is the net farm income, plus the change in market valuation of assets that were adjusted  for inflation or deflation on the year-end balance sheet.

Rate of return on farm assets

Rate of return on farm assets can be thought of as an interest rate your farm earned in the past year on all money invested in the business.

In the FINPACK analysis, there is a cost measurement and a market measurement. The cost measurement represents the actual return on the average dollar (average of the beginning of year and the end of the year) invested in the business. The market measurement can be looked at as the opportunity cost of investing money in the farm, instead of alternative investments.

Commonly accepted ranges

• Greater than 8 percent is strong.

• Between 4 and 8 percent is in the caution range.

• Less than 4 percent is considered vulnerable.

Rate of return on farm equity

Rate of return on farm equity is the interest rate your equity (net worth) in the business earned in the past year.

In the FINPACK analysis, there is a cost measurement and a market measurement. The cost measurement represents the actual rate of return to the amount of equity capital you have invested in the farm business. The market measurement can be compared to the returns available if the assets were liquidated and invested in alternative investments.

Commonly accepted ranges

• Greater than 10 percent is thought to be strong.

• Between 3 and 10 percent is in the caution range.

• Less than 3 percent is considered to be vulnerable.

An important study can be made by comparing your return on assets to your return on equity. If your return on assets is higher than your average interest rate paid on borrowed money, your return on equity will be still higher. This indicates a positive use of financial leverage, meaning that your loans are “working for you.”

If your return on assets is lower than your average interest rate, then your return on equity will be still lower. This indicates a negative financial leverage, meaning that your loans are “not working for you” at this time.

Operating profit margin

Operating profit margin is a measure of the operating efficiency of the business. It indicates the average percentage operating profit margin per dollar of farm production. It measures how effectively you are controlling operating expenses relative to the value of output.

Low prices, high operating expenses or production problems are all possible causes of a low operating profit margin.

Commonly accepted ranges

• Greater than 25 percent is considered strong.

• 25 to 15 percent is considered in the caution range.

• Less than 15 percent is considered to be vulnerable.

By itself, the operating profit margin is not adequate to explain the level of profitability of your business, but it is used along with another ratio to produce the rate of return on farm assets.

EBITDA

Earnings before interest taxes depreciation and amortization (EBITDA) is not a ratio, but a measurement. EBITDA measures earnings available for debt repayment. There is no standard acceptable dollar amount for EBITDA, as the amount needed is tied to farm size and needs.

Repayment capacity is measured by the term debt coverage ratio and the capital debt replacement margin. These measurements come from the statement of cash flows.

Net farm income, plus non-farm income must cover family living, income taxes and social security taxes, and then cover the payments on term (intermediate and long-term) loans. The term debt coverage ratio measures the ability to meet these payments. If anything is left over after the payments are made, that is the capital debt replacement margin.

Term debt coverage ratio

Term debt coverage ratio is expressed as a decimal and tells whether your business produced enough income to cover all intermediate and long-term debt payments.

• A figure of 1.00 indicates that payments could be met, but with nothing to spare.

• A figure less than 1.00 indicates the ability to make these payments was less than adequate.

• A figure greater than 1.00 indicates the payments could be made, and there is room to spare.

Commonly accepted ranges

• Greater than 1.75  is considered strong.

• 1.25 to 1.75 is considered in the caution range.

• Less than 1.25  is considered to be vulnerable.

Capital debt replacement margin

Capital debt replacement margin is the amount of money remaining after all operating expenses, taxes, family living and debt payments have been accounted for. It is the cash generated by the farm business that is available for financing the purchase of capital replacements such as machinery and equipment.

If the term debt coverage ratio is greater than 1.00, then the capital replacement margin (dollars left over after the payments are made) is a positive number. That is good. If the term debt coverage ratio is less than 1.00, then the capital replacement margin is a negative number. That is not good.

Commonly accepted ranges

• Greater than 1.75  is considered strong.

• 1.25 to 1.75 is considered in the caution range.

• Less than 1.25 is considered to be vulnerable.

FINPACK produces five efficiency measures, asset turnover rate, operating expense ratio, depreciation expenses ratio, interest expense ratio and net farm income ratio. Other financial software and paper forms products will generate similar measurements.

Asset turnover rate

Asset turnover rate is a measure of the efficiency of using capital. It is the amount of gross production per dollar of investment. Neither the asset turnover rate nor the operating profit margin (discussed earlier) are adequate to explain the level of profitability of the business, but when used together, they are the building blocks of the farm’s level of profitability. (Operating Profit Margin x Asset Turnover Rate = Rate of Return on Assets)

Commonly accepted ranges

• Greater than 45 percent  is considered strong.

• 30 to 45 percent is considered in the caution range.

• Less than 30 is considered to be vulnerable.

Operating expense, depreciation expenses, interest expense and net farm income ratios

The other four efficiency measurements can be thought of as pieces of the same pie. The operating expense ratio, depreciation expense ratio, interest expense ratio and net farm income ratio reflect the distribution of gross income. When added together, they will always equal 100 percent.

You could look at these four together, while asking yourself “OK, I had gross income of so much, where did it all go?” The biggest share likely went to the pay the operating expenses, some went to depreciation, some went to pay interest and you got to keep the rest (net profit).