Using statements and ratios to assess financial success

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“When I want to know how my farm is doing financially, I just check my bank account.” Accountants and lenders shake their heads when they hear this sort of statement. While it’s important to monitor your bank balance, it provides limited information on how your farm is performing financially.

Financial statements

To make informed decisions, you need these three commonly-used financial statements – the balance sheet, income statement (profit and loss), and cash flow statement.

Balance sheet:

• Displays the company’s assets, liabilities and shareholders’ equity

• Assets = Liabilities + Shareholders' Equity

• Snapshot of financial position at a specific point

Cash in the bank is just one element of your asset base. It doesn’t tell you anything about the farm’s liabilities.

Income statement:

• Shows revenues and expenses over a specific time

• Revenues less expenses results in the net income for the business

• Accounts for depreciation, receivables, payables and inventory changes (accrual basis)

• Used to assess profitability over a period of time, usually a month or year.

Cash in the bank doesn’t tell you if the operation was profitable in the past fiscal period. Only an income statement can tell you that.

Cash flow statement:

• Shows the net change in cash position over a specific period

• Adjusts for non-cash expenses such as depreciation

A cash flow statement shows what occurred and can assist with preparing your cash flow budgets as you project your cashflows into the future. On its own, your bank balance doesn’t have much value if you don’t account for upcoming expenses and revenues.

Note: Information from the balance sheet and the income statement is needed to create the cash flow statement. Accounting software programs like AgExpert Accounting can automatically generate all three of these financial statements.

Financial ratios

With the information reported in the financial statements, you can calculate financial ratios for a deeper dive into your financial situation. Ratios can also help you pinpoint opportunities and challenges.

Current Ratio

The current ratio (also known as liquidity) calculates your ability to meet financial obligations as they come due.

Current Ratio = Current Assets / Current Liabilities

Current assets are short-term liquid assets that can reasonably be converted to cash in a year. Current liabilities are expenses and payments due within the year.

A ratio above 1.5 is considered ideal with 1.25 being acceptable by most lenders. Higher suggests your money could be working harder. Lower than 1.0 means a farm lacks the current assets to cover current liabilities and would require additional cash either through an operating loan or owners’ cash injection.

You can use your current ratio to compare against others in your sector. More importantly, you can track your current ratio over time to better understand changes in your operation. If your current ratio is declining, it’s a sign your cash is getting depleted usually because expenses are higher than the revenues.

It’s also important to use a cash flow budget to track the timing of cash inflow and outflow. Even with a strong current ratio, issues arise if you don’t plan. For example, a cash crop producer spends a lot of money on inputs before any crop is available for sale. The current ratio for the year may look good, but a cash flow budget will show if there is a cash deficit that they need to plan for.

Debt Service Ratio

The debt service ratio (DSR) is a similar calculation to the current ratio - it measures an operation’s ability to service or pay back it’s debt. It’s one of the first indicators a lender will examine when you’re requesting to borrow more money.

DSR = Net Income Available for Debt Servicing / Debt Service

The net income available for debt servicing is, net farm income after taxes + term debt interest + depreciation – owner’s drawings (living expenses)/dividends + net off-farm income. Depreciation (or capital cost allowance) is added back in because it is not a cash cost.

Debt service includes all debt obligations due in a year, including short-term debt and the current year’s principal payments of long-term debt that will be paid, including interest.

As with the current ratio, a DSR of 1.5 is considered healthy, while a ratio below 1.0 indicates a difficulty in servicing debt because the operation is not generating enough cashflow. Remember, cash is king, and a cash flow budget can highlight issues even with a healthy current ratio or debt service coverage ratio.

Debt-to-asset and debt-to-equity ratios

While the current ratio and the debt service coverage ratio measure liquidity, the debt-to-asset ratio measures solvency and the ability for an operation to meet long-term financial obligations.

Debt-to-Assets Ratio = Total Liabilities / Total Assets

Note that total liabilities include long-term debt for equipment, vehicles, farmland and quota, as well as short-term liabilities such as a line of credit, operating loan and unpaid invoices and credit card balances.

Total assets included fixed assets such as farmland, buildings and equipment as well as current assets like inventory and prepaid supplies.

The debt-to-asset ratio indicates the amount of debt for each dollar of assets. Although financial advisor’s views may differ slightly, a ratio of less than 0.25 is strong, between 0.25 and 0.60 is satisfactory, and more than 0.60 is concerning (highly leveraged), this means 60% of all of your assets are financed with debt.

Other ratios are often used to express the same information in different ways. For instance, the debt-to-equity ratio is total farm liabilities divided by total farm equity. In this case, a ratio of less than 0.6 is strong, with 0.60 to 1.0 as satisfactory and more than 1.0 as weak.

Example:

If a farm’s total assets are worth $1 million and the total debt is $300,000, the owner’s equity is $700,000.

The debt-to-asset ratio is $300,000, divided by $1 million, which is 0.30 and considered satisfactory.

The debt-to-equity ratio is $300,000 divided by $700,000, which is 0.43, which again is satisfactory.

When you hear a business is highly leveraged, it has high debt relative to its equity. For instance, if the leverage of your farm is 2.0, it means creditors have invested $2 in your business for every $1 that you have. Generally, lenders aren’t comfortable adding more debt to an already highly leveraged business. They risk losing more than the owner if the business fails. But, if your leverage is low, you have strong equity and will have the ability to financing new opportunities.

Cost of Production ratio

The cost of production ratio (CoPR) measures an operation’s variable costs relative to its gross revenue.

CoPR = Total Direct Variable Expenses / Gross Revenue

Direct variable expenses are corelated to the size of the operation such as labour, feed, crop protection products, fuel, and crop/livestock insurance. Amounts such as loan payments, depreciation, property taxes, land rent expense and capital improvements are not part of the Cost of Production ratio as they are fixed in nature.

If your CoPR is 60%, it indicates that you’re spending 60% of revenue on variable expenses or 60 cents out of every dollar. If your CoPR is too high, it reduces the cash available to cover fixed costs and build equity.

Different sectors within agriculture typically have different CoPRs. This ratio is best used to capture what’s happening in an operation over several years. The CoPR increases when expenses rise more rapidly than revenue. The ratio should be used in conjunction with other ratios to accurately assess overall financial health and look at trends over time for your operation.

Reducing direct variable expenses without losing gross revenue improves a farm’s efficiency. There are many ways to do this, but it takes proactive management and attention to detail. An example would be buying fertilizer well in advance of seeding when prices are typically lower.

Return-on-Assets Ratio

The Return-On-Assets ratio (ROA) is a measure of farm profitability relative to total assets. The higher your ratio, the better you are leveraging assets to turn a profit. While there’s no ideal ROA, a higher ROA makes it easier to service debt and ultimately increase your equity in the business.

ROA = Net income / Total assets

Considerations when using ratios

• Different ratios can be used to calculate and assess your farm’s financial situation and have a place in decision making. However, year-to-year comparisons should be made for similar timeframes, typically at the end of the fiscal year. Watching the trends of these ratios will indicate how the financial strength of your business is trending.

• Don’t use ratios in isolation. Your current ratio might look strong because your liabilities are low, but your working capital (current assets - current liabilities) might be minimal.

• Ratios don’t pay the bills - cashflow does.

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