Understanding financial ratios key to farm health
Our report FCC Ag Economics: 2016-17 Outlook for Farm Assets and Debt provides an overview of the financial health of Canadian farms and offers projections about farmland values and farm debt.
Canadian agriculture remains in a strong financial position. The balance sheet of agriculture is healthy, but could face some challenges as farm income flattens and land appreciation slows.
Yet, financial risks for Canadian farms remain small with projections of low interest rates and strong net cash income supportive of the balance sheet.
Financial ratios are used to look at liquidity, solvency and profitability of agriculture. Knowing these ratios is a first step in building the financial picture of your operation.
Here’s how to calculate your own current ratio, debt-to-asset-ratio and return-on-assets ratio:
1. Current Ratio: measuring liquidity
Calculating your current ratio
Liquidity is your first line of defense when an operation experiences difficulties.
Current assets are short-term liquid assets that can reasonably be converted into cash in a year. It includes cash, inventories of inputs and finished products, and accounts receivables (money you are owed and are expected to be paid in a year).
Current liabilities are expenses and payments due in a year. It includes unpaid invoices for inputs such as seed and animal feed, and payments for a mortgage or a line of credit.
The current ratio is constructed by dividing the value of current assets by the value of current liabilities.
Current Ratio = current assets/current liabilities
A current ratio above 1 is ideal because it shows current assets are greater than current liabilities. The higher the current ratio the more liquid the operation. But be mindful that a ratio which is too high can also suggest you aren’t putting your money to work.
2. Debt-to-Assets Ratio: measuring solvency
Calculating your debt-to asset ratio
The debt-to-asset ratio is constructed by dividing the value of total liabilities by the value of total assets. It measures the proportion of total assets financed by debt, an indicator called leverage.
Total liabilities include long term debt (e.g., vehicle and mortgage debt) as well as short-term liabilities (e.g., line of credit and unpaid invoices).
Debt-to-Assets Ratio = total liabilities/total assets
A lower debt-to-asset ratio brings flexibility to an operation if it has to withstand unexpected challenges, or to seize opportunities that arise in the marketplace (such as expansion, diversification, etc.).
3. Return-on-Assets Ratio: measuring profitability
The return-on-assets ratio is calculated by dividing net income by the value of total assets.
Calculating your return-on-assets ratio
Net income is revenues minus operating expenses. Revenues are cash brought in as a result of business activity. For example, revenues could be crop yields (or animal weights) multiplied by the price received per bushel (or per animal). Expenses include all operating expenses. But be careful, prepaid expenses (e.g., fertilizer purchased this year for use next year) are not to be included in the calculation for net income this year.
Return-on-Assets Ratio = net income/total assets
A higher return-on-assets ratio means that a farm is more profitable, and is better able to leverage assets to turn a profit.
Agricultural operations are all different. These three ratios will vary depending on size, sector, and the maturity of the business. Monitoring the trends in these ratios will provide a picture of the financial health of your operation.
Madeline Turland, Ag Economics Student Intern