Focus on Agriculture: Using financial statement ratios

As discussed in my last article, while financial statements are the measuring stick for farm business analysis, many farmers do not use them to their full potential. Taking it to the
next step, financial statement ratios can be used in everyday farming, no different than yield per acre, pounds gained per day, or percentage calf crop.

There are three main types of ratios that are common : liquidity, solvency and profitability.

This article will focus on liquidity and solvency.

Liquidity is a measure of the farm’s ability to meet its financial obligations (debts) as they come due without disrupting the normal business operations.

It measures the relationship between current assets and current liabilities.

Current assets are the assets that are cash, or can be easily converted to cash – what’s in the bin, the barn, and the bank. Current liabilities are due in the next year – for example an operating loan and/ or the current portion of the long term debt that is due in the next 12 months.

Common liquidity measures are the current ratio, working capital and debt structure ratio.

• The current ratio measures the current assets available to cover the current liabilities. A strong current ratio is greater than 2:1, or for every dollar of liabilities due, there is $2
available to cover them.

This would be ideal for an operation with seasonal cash flow, such as a cowcalf operation or a grain farm. If cash fl ow is more regular, like a dairy operation, then a lower current ratio could be safe.

• Working capital is another measure of liquidity, calculated by taking the current assets minus the current liabilities. It measures the cash available to operate the business after the current liabilities have been paid. Remember this is a snapshot in time, and may not be realistic if the farm manager is unable to sell inventory, or collect on accounts receivable.

• Debt structure is calculated by dividing the current liabilities by the total liabilities. Generally, less than 20 per cent is an acceptable debt structure, meaning that the operation is scheduled to pay back 20 per cent or less of the total debt in the year. Having a higher debt structure can be acceptable if the total amount of debt is low, and should be considered in conjunction with the current ratio and the working capital.

Solvency measures the ability of the business to meet its total debt obligations if all its assets were sold (either by choice or not). If the market value of the total assets is greater than the market value of the liabilities, the business is said to be solvent.

Common measurements of solvency include net worth, debt to asset ratio, and debt to equity ratio.

• Net worth is simply the money left over if the assets of the business were sold and debts paid. Having a net worth that increases over time measures financial progress.

• Debt to asset ratio, sometimes called the solvency ratio, is the total liabilities divided by the total assets. This ratio measures the farm’s ability to pay off all its debt if the assets were sold. A debt to asset ratio of less than one means the business is solvent.

• Debt to equity ratio, also called the leverage ratio, measures the amount of owned capital to the amount of borrowed capital, and measures fi nancial risk. Less than 50 per cent is a desired ratio, and the higher the ratio, the greater the exposure to financial risk.

Financial statement ratios generated by the farm can be compared to benchmarks set for the industry, but it is usually more valuable to compare your business against itself over a period of years. This can help you to identify trends within your business. It is important to remember that decisions will be no better than the information they are based on, so it’s important that information
is accurate and complete.

Combining good judgment and common sense with financial statement analysis will increase decision-making ability.

Ratios should be looked at in combination, as there are limitations when used alone. My next article will focus on profitability ratios and measures.

The Ministry of Agriculture has the Comprehensive Guide to Financial Management available on the website (www.agriculture.gov.sk.ca). The guide is divided into five main sections:
• Interests, motivations, goals and purpose;
• Record keeping and accounting fundamentals;
• Farm financial statements;
• Financial analysis and determining farm fi nancial health, and
• Action planning..

There are sub-sections within each of these main sections, identifying specific tools and sources of information to assist with education and comprehension of financial nanagement.

The guide outlines suggested processes and highlights some key resources that may be helpful, but it is not intended that a farm manager would use all resources in the guide at all times. Depending on the level of understanding the manager currently has, only some of the resources in the guide may apply. This guide is not intended to be a complete list of all available
resources.