Financial Performance Measures for Iowa Farms
Farmers who have a large investment in land, machinery, livestock, and equipment need to keep informed about the financial condition of their operations. Some useful measures of financial performance can be calculated from information found in most farm record books and accounting programs.
These measures can help farmers assess the profitability, debt capacity, and financial risk currently faced by their businesses. The measures presented in this publication are based on guidelines of the Farm Financial Standards Council and are used by most agricultural lenders and farm accountants.
Types of Measures
Five different areas of financial condition are measured. Liquidity refers to the degree to which debt obligations coming due can be paid from cash or assets that soon will be turned into cash. This is measured by the current ratio, the amount of working capital, and the amount of working capital per dollar of gross revenue. A more thorough analysis of liquidity can be made with a cash flow budget. AgDM File C3-15, Twelve Steps to Cash Flow Budgeting, explains this tool in detail.
Solvency refers to the degree to which all debts are secured, and the relative mix of equity and debt capital used by the farm. The total debt-to-asset ratio is one of several ratios used to measure solvency, all of which are based on the same relationship of assets, liabilities and net worth.
Profitability refers to the difference between income and expenses. One important measure of profitability is net farm income. Annual rates of return on both equity capital and total assets also can be calculated and compared to interest rates for loans or rates of return from alternative investments.
Financial efficiency ratios show what percent of gross farm revenue went to pay interest, operating expenses, and depreciation, and how much was left for net farm income. The asset turnover ratio measures how much gross income was generated for each dollar invested in land, livestock, equipment, and other assets.
Repayment capacity measures show the degree to which cash generated from the farm and other sources will be sufficient to pay principal and interest payments as they come due.
Using Performance Measures
Values for the farm financial measures should be calculated for several years to observe trends and to avoid making judgments based on an unusual year. Typical historical values for most of these measures can be found in the tables at the end of this publication. They are based on data obtained from the Iowa Farm Business Associations. Values will vary according to the major enterprises carried out, farm size, location, and the type of land tenure. Other comparable data can be found in the annual Iowa Farm Costs and Returns (AgDM File C1-10).
Farms with good liquidity typically have current ratios of at least 3.0 or higher. Dairy farms or other farms that have continuous sales throughout the year can safely operate with a current ratio as low as 2.0, however. Conversely, operations that concentrate sales during several periods each year, such as cash grain farms, need to strive for a current ratio higher than 3.0, especially near the beginning of the year. In recent years, current ratios for many farms have risen rapidly.
The amount of working capital needed depends on the size of the operation. Records show that working capital measured at the beginning of the year is typically equal to about 40 to 70 percent of the farm’s annual gross revenue. For dairy farms, working capital can be as low as 30 percent of gross revenue, but cash grain farms may need as much as 50 percent.
Total debt-to-asset ratios tend to be higher for larger farms and for farms that specialize in livestock feeding. Ratios of 10 to 30 percent are common among Iowa farms, although many operate with little or no debt. A high debt load does not make farms less efficient, but principal and interest payments eat into cash flow. High efficiency farms are able to service a higher debt load safely.
Two other ratios are commonly used to measure solvency. The equity-to-asset ratio shows how many dollars of net worth a farm has for every dollar of assets. It is equal to 100 percent minus the debt-to-asset ratio. Higher equity-to-asset ratios indicate a less risky financial situation. Some lenders prefer to use the debt-to-equity ratio to measure solvency. Higher ratios indicate more risk.
Another useful measure is how much net worth the farm has for each crop acre farmed, especially for cash grain farms. The IFBA average is nearly $3,000.
Net farm income is highly variable from year to year, and is closely tied to the size and efficiency of the operation. It also depends on the amount of debt the farm is carrying. The rate of return on farm assets is quite variable, too, but average long-term rates of 6 to 10 percent have been common in Iowa. High-profit farms may average more than 12 percent, while low-profit farms often realize a return of only 2 percent or less.
The average rate of return on farm equity measures how fast farm net worth is growing, excluding changes in land and machinery values. Highly leveraged farms may earn little or no return on equity when interest rates are high. On the other hand, if the farm’s overall return on assets is higher than the cost of borrowed money, the return on equity may be quite high and net worth will grow rapidly.
Operating profit margin is equal to the dollar return to capital divided by the value of farm production each year. Ratios have averaged about 25 to 30 percent in recent years. High profit farms have had ratios of 35 percent or more, while low profit farms have had ratios of less than 15 percent. Farms that hire or rent assets such as labor, land, or machinery will have a lower operating profit margin because operating costs are higher. However, they will usually generate a larger gross and net income. Farms with owned or crop share rented land will have a higher operating profit margin because they have lower operating expenses.
Another common measure of profitability is Earnings Before Interest, Taxes, Depreciation, and Amortization, abbreviated as EBITDA. It shows how many dollars are available for debt repayment.
Asset turnover ratios for typical farms are about 30 to 40 percent, but they can range from 20 to 30 percent for low profit farms and up to 40 to 50 percent for high profit farms. The asset turnover ratio measures the efficient use of investment capital while the operating profit margin ratio measures the efficient use of operating capital. Because they are substitutes for each other (owned and rented land, for example), farms that are high in one measure may be low in the other.
Farms with mostly rented land should have higher asset turnover ratios than farms with mostly owned land, generally around 50 percent. Rented farms also will have higher operating expense ratios because rent paid is included in operating expenses. Likewise, rented farms will tend to have lower depreciation and interest expense ratios than owned farms. Typically, about 60 to 70 percent of gross revenue goes for operating expenses, 5 to 10 percent goes for depreciation, and under 5 percent goes for interest.
The average net farm income ratio for Iowa farms has been in the 20 to 30 percent range in recent years. High profit farms have averaged from 30 to 40 percent, and low profit farms less than 15 percent.
The farm record data that was available did not contain enough information to calculate historical repayment capacity measures. However, the term debt coverage ratio should at least be great than 1.0, and the capital debt repayment margin should be large enough to cover any possible shortfalls in cash flow that cannot be paid from savings or other sources of short-term liquidity. These measures include nonfarm income and expenses, so do not measure business performance.
If comparisons show that a farm’s financial performance is below average, further analysis should be done to determine the sources of the problem. Areas of possible concern are production efficiency, marketing, purchasing of inputs, and the scale of the operation in relation to the size of the work force. Enterprise analysis and production records can help identify problems that contribute to poor financial performance.
Calculating these financial performance measures for several years will reveal a great deal about the financial health of a farm business. Particular attention should be paid to any trends that are developing. Any decisions about investments or borrowing, however, also should consider current and future economic conditions, availability of collateral, and the experience and character of the farm operator.
The worksheet at the end of this publication shows the basic information needed to compute the financial measures. Asset and liability values should be recorded as close to the beginning and ending of the accounting year as possible. Include only farm assets, liabilities, and any property or investment that generates returns included in farm income.
For calculating the financial performance ratios, farm assets should be valued at their current fair market value, minus any potential selling costs and income tax payments.
Scheduled principal and interest payments on term debt include interest and principal that will have to be paid during the next year on intermediate and long-term farm loans. Do not include operating or other short-term loans. For loans amortized on an equal annual payment schedule, simply use the total payment due in the next year. For other loans add the principal portion due in the next year to the amount of interest that will have to be paid. Also include any long-term lease payments for machinery and equipment (but not land) that will come due.
Gross farm revenue refers to total farm sales and miscellaneous farm income. Cash income should be adjusted to reflect changes in inventories of crops, livestock, and accounts receivable. Gross farm revenue does not include nonfarm income, loan funds received, nor income from sales of machinery, equipment, and real estate.
Net farm income from operations is the difference between gross revenue and total farm expenses, including interest and depreciation. Farm capital gains and losses is the difference between the selling price of any depreciable asset sold during the year and its adjusted basis (depreciated value).
Interest expense is equal to the cash interest paid plus or minus the change in the amount of accrued interest owed at the end of the year. Depreciation expense should be the same value as used on the farm income statement, whether calculated for income tax purposes or by other accounting methods.
Nonfarm income, family living expenses, and income tax payments can be estimated from personal records. Common farm wage rates in the community can be used to value unpaid labor and management.