How Do You Measure Up?

October 5, 2011 11:53 AM

By Denise Bedell

Analyze financial ratios to prepare for market downturns

Financial ratios allow a business to measure itself against its previous performance and against its peers. They can also show where new opportunities lie and where greater efficiency can be gleaned. Not to mention, ratios provide an early warning system for potential financial shocks.

Financial ratios take information from three sources: the balance sheet, the income statement and the cash flow statement. Most of this information is also available from the balance sheet that farmers have to produce for lenders. The data is then used to look at financial performance in five areas: liquidity, solvency, profitability, repayment capacity and financial efficiency.

These ratios are a key tool to help producers plan, budget and make capital expenditure decisions. "It is important to know how liquid and how solvent you are," says Hal Pepper, financial analysis specialist at the Center for Profitable Agricul-ture, University of Tennessee.

Pepper notes that liquidity and solvency ratios provide a clear idea of whether restructuring needs to be done, by looking at the farm’s current ratio, for example. The current ratio is a financial measure equal to total current assets divided by total current farm liabilities—or what is owned divided by what is owed.

"If the ratio is greater than 1.0, the operation is considered liquid," Pepper explains. "The higher the ratio, the greater the liquidity."

Protect against the Future. In a period of market strength—as is the case now—it is more important than ever that producers make good decisions on how they spend their money, in order to protect against the tougher financial conditions that will occur when prices drop.

Plus, by producing and regularly maintaining financial records and using ratios for better farm management, it shows lenders that financial management is a priority.

"In a period like this where there ought to be profitability on a farm, we want to focus on making investments that affect return on assets," explains William Alan Miller, farm business management specialist in the Department of Agricultural Economics at Purdue University.

"Some farmers might be focused on buying items that can be deducted from taxes, especially with higher income, but when crop prices go back down, it might have been a better idea to have invested in things that allow them to become more profitable over the longer term," Miller says. "Before you can think in those terms, you have to do some measurements. If you don’t know how you’re doing, how can you tell where you need to improve?"

Miller says the two ratios he finds most useful are the asset turnover ratio and the operating profit margin ratio, which can be multiplied together to get return on assets. "Those two ratios are the key indicators of operating performance. How productively did I use my resources to generate revenue, and how much of that revenue did I keep?" he says.

Then, by benchmarking against peers, it can tell you how well you’re using your assets. Miller says there is little difference between top-tier farms and average farms in operating profit margin ratios. The real difference is in asset turnover: Top-tier farms are getting more revenue dollars for their assets employed.

Analyzing financial ratios is relatively simple and inexpensive—and is invaluable in improving
efficiency and profitability and reducing the impact of future market downcycles.

Sweet 16 Becomes Legal 21

The Sweet 16 financial ratios that are important to sound farm financial management have been expanded to include five new ratios:

  • Working capital to gross income: Measures available operating capital versus the size of the business.
  • EBITDA, or earnings before interest, taxes, depreciation and amortization: Measures earnings available for debt repayment.
  • Capital debt repayment capacity: Measures all sources of income that could be used to pay debt.
  • Replacement margin: Measures the ability to generate funds for debt repayment with maturities longer than one year and the ability to replace assets.
  • Replacement margin coverage ratio: Shows if income covers term debt payments and cash contributions for new equipment.
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