Use ratios to analyze farm finances
Farmers seeking to delve deeper into the business side of their operations might want to take advantage of analysis tools like financial ratios.
Expressed as percentages or as a comparison, financial ratios compare two or more elements of financial data, explains John Molenhuis, Ontario Ministry of Agriculture, Food and Rural Affairs’ business analysis cost production specialist.
Sharon Ardron, a Manitoba Agriculture farm management specialist, recommends farmers use three to five years of financial data from their operations when conducting ratio analysis in order to provide a good trend line.
“This will provide a strong base against which to compare the current year’s performance, and provides good context to those ratios,” Ardron says.
Debt service coverage ratio
A debt service coverage ratio reveals how a farm operation’s cash flow is being used to cover debt obligations, Ardron says.
The standard minimum for agriculture is 1.25:1, which means that for every dollar of debt, the farm is generating $1.25 to cover its financial obligations, she says.
A ratio below 1.0 means an operation isn’t generating enough revenue to service its debt obligations, adds Farm Credit Canada’s Jeff Walkeden.
Operating expense ratios
Walkeden calls this ratio a snapshot of how a farm is spending its money on operations.
An operating expense ratio is a snapshot of how a farm is spending its money on operations. Typically, the lower the ratio, the better the business is performing.
Manitoba Agriculture notes an operating expense ratio of 60 per cent indicates an operation spends that percentage of its revenue on variable expenses.
Typically, the lower this ratio, the better the business is performing, Ardron says. If the ratio is too high, revenues may be unable to cover expenses.
“This can leave the business vulnerable to financial risk if prices were to decrease or expenses were to unexpectedly increase,” Ardron says.
Also referred to as a debt-to-equity ratio, the leverage ratio indicates the relationship between the use of debt and equity to finance the business of the farm, Molenhuis says.
“A higher leverage ratio indicates a higher fixed commitment - less flexibility - and therefore, higher risk,” Molenhuis says.
Usually a ratio of less than 0.40 (2:5) is considered strong, according to Manitoba Agriculture.
“A weak leverage ratio means that if a severe shock to the business were to occur, the business may struggle with handling that obligation and the ability to refinance its debts to keep operations going,” Ardron says.
For new farms or ones expanding, the ratio will tend to be higher, whereas the ratio for established farms are more likely to be lower, Walkeden notes.
Comparing two or more elements of financial data helps provide an in-depth financial picture of a farm operation in areas such as debt service coverage, operating expenses or leverage ratios. Financial experts say ratios are an excellent way to compare the current year’s performance with past years.
Article by: Richard Kamchen