How to analyze financial condition and performance for your farm
Improving Your Farm Profitability: #5
by Craig Chase, FFED program manager
When large companies evaluate their business, they are determining their company’s financial condition and performance. What do those terms mean?
Get a picture of your farm’s financial condition from its balance sheet. This indicates the value of the assets, liabilities and net worth of the company on the date you created the balance sheet (normally at year-end).
Determine the farm’s financial performance from its income statement. This data indicates the profitability of the company over a designated time period (normally one year). If you have developed a current balance sheet and income statement, you can evaluate your business’s financial condition and performance.
Analyzing your balance sheet
Let’s start with the balance sheet. The general things you look for with a balance sheet are, can the business pay its bills and does the business have too much debt? Determine your ability to pay bills using the current ratio, which is your current assets divided by your current liabilities.
Is this ratio greater than 1.0? If yes, then your current assets (those assets that are cash or can quickly be converted to cash) are greater than your current liabilities (payments due in the next 12 months requiring cash). The higher the number (should be greater than 1.5), the greater your liquidity. This is the financial term for your ability to pay your bills.
The debt-to-asset ratio measures how much you owe (total liabilities) versus how much you own (total assets). If this number is greater than .5, this indicates you owe more on your assets than you own. In other words, the bank or other lender(s) have claim to a larger share of your business than you do. The lower the number, the better. A number under .4 normally indicates a comfortable balance between debt and assets (i.e., your business is financially solvent).
Analyzing your income statement
From the income statement, you can determine how efficient you are with the dollars in revenue you bring in. You can determine how much of your sales revenues go toward operating expenses (operating expense ratio), depreciation (depreciation expense ratio), interest (interest expense ratio), and net income (net income ratio).
These four ratios must add up to 100 percent. This way they will reflect all your sales dollars when divided into the four categories. In other words, if operating expense ratio, depreciation ratio, and interest expense ratio add up to 85 percent, then the net income ratio is automatically 15 percent. This indicates that $0.15 out of every $1 of sales goes toward net income.
The more efficient the business, the lower the first three category expense ratios are, and the larger the net income ratio is. To measure profitability, you can simply evaluate your net farm income. Is it where you want it to be?
You can also develop debt coverage ratios by making adjustments to your net farm income and dividing that adjusted number by the total amount of your scheduled principal and interest payments. Again, this number must be over 1.0, and the higher the number, the better.
A few more ratios
You can also develop different ratios using a combination of the balance sheet and income statement. For example, to determine if your business is at an appropriate scale, the asset turnover (ATO) ratio can be used. Calculate your asset turnover as your annual gross revenue (from your income statement) divided by the average total assets of your business (from beginning and ending balance statements).
An ATO ratio of .45 indicates you are generating $45 in annual sales for every $100 in assets. Remember, if you lease most of your assets rather than own them, this ratio will not make much sense.
You can make use of 21 common financial ratios to determine the financial condition and performance of your farm business. Choose the ones that make most sense for you and your farm. I recommend you evaluate one or two ratios from each of the following five categories: liquidity, solvency, profitability, debt repayment, and efficiency.
You can find a list and definitions of these ratios in the Ag Decision Maker article Financial Ratios.