Consultants and Extension economists urge the careful evaluation of business partners today—suppliers and buyers alike. But assessing financial health is not simple.
“There are a number of measures that financial analysts use for this purpose,” says Ann Duignan of J.P. Morgan. “It’s most important to look at trends or changes from the norm, as absolute numbers may not be meaningful,” she emphasizes.
A CoBank publication to help farm co-op managers and directors lists four kinds of financial statements, and almost a dozen ratios, that can be used to evaluate a co-op’s status:
1. Operating or profit-or-loss statement. Gives results for a specific length of time such as monthly, year-to-date or annually. Major sections include income, expenses and savings or net operating gain.
2. Balance sheet. A financial snapshot of the business, usually at the end of the month, quarter or fiscal year. It includes assets (current and fixed), liabilities (current and long-term) and co-op members’ equity.
“From the balance sheet, you can generate the debt-to-equity ratio,” Duignan says. “Clearly, if a company is borrowing more, you would want to know the reason why.”
3. Cash-flow statement. Provides a tool for analysis of cash to meet obligations for debt service and equity retirement or to meet ongoing investment needs. The absolute change in cash during the accounting period is not as important as trends in the three sources of cash flows: operations, investing and financing.
4. Changes in financial position. Summarizes sources and uses of funds. According to CoBank, “Many lenders consider the Statement of Changes in Financial Position to be one of the most important and informative.”
The bottom line is working capital. If uses exceed sources over time, working capital decreases—a red flag that indicates the business may have difficulty meeting its current obligations. However, this may not be true if the business is growing rapidly.
The working capital needed de-pends on the quality of current assets (how current accounts receivable are, for example), the size of the business and management’s ability to use cash effectively. If the cost of running the business exceeds net income over time, that could be another red flag.
Change talks. Most importantly, ask about changes, Duignan says. “Examples would be if there is a big change in receivables as a percent of sales, or inventories as a percent of the cost of goods or sales. The key question is why. The answer lets you figure out whether it is temporary or permanent and whether or not the company can deal with the problem.
“Financial analysis is all about looking for anomalies and figuring out whether they point to a trend that’s going in the wrong direction,” she sums up.
Four ratio types
Once you have financial statements in hand, there are four types of ratios to help you digest what they mean. Within each type, there are several measures, based on the various statements.
Profitability: The ability to generate “savings” or excess cash over expenses.
Liquidity: Short-term cash flow. 1. Working capital to sales; 2. current ratio.
Efficiency: How well things are done. 1. Productivity ratio based on operating statement; 2. labor-to-income ratio.
Solvency: Long-term financial health and stability. 1. Term debt-to-net fixed assets; 2. local leverage ratio; 3. ownership ratio.
To contact Linda H. Smith, e-mail lsmith@farmjournal.com
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Top Producer, March 2009
