“What's considered enough money? Just a little bit more.”— Will Rogers
“If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem.”—John Paul Getty
What are the key areas of financial performance and financial position that an operation should be focusing on and managing? Financial measures outlined by the Farm Financial Standards Council are grouped under five areas: liquidity, financial efficiency, profitability, solvency, and repayment capacity. All of which measure either financial position or financial performance. Of the sweet 16 ratios, we will focus on 6 that are especially important during these times of very tight commodity prices for the farmer.
1. Working Capital
The primary liquidity measure is working capital, which is calculated as current assets minus current liabilities. What constitutes adequate working capital is related to the size of the farm business. Ideally, working capital should be greater than 20% of gross revenue (gross income).
2. Current Ratio
A second critical liquidity measure is the current ratio, which is calculated by dividing current assets by current liabilities. The higher the ratio, the more liquid the business is considered to be. A ratio of 1.25 or higher is generally preferred in order to allow for adverse price changes, production shortfalls, or input price increases during the upcoming year. Highly leveraged operations that rent most of what they farm for cash need to exercise special care. Strengthening and managing your liquidity ratios now will help you weather any future volatility.
3. Asset Turnover Ratio
Efficiency is getting more output from the same resources or getting the same output from fewer resources. You can use ratios to measure production or financial efficiency or a combination of both.
For financial efficiency, the primary measure is the asset turnover ratio. The ratio is calculated by dividing gross farm revenues by average total farm assets. This measures how efficiently farm assets are being used to generate revenue. An asset turnover ratio of 60% or higher is considered a healthy and efficient use of assets. Generally, the higher the ratio, the more efficiently assets are being used to generate revenue. When the asset turnover ratio is multiplied by the operating profit margin ratio, the result is the rate of return on assets. A major challenge for agricultural producers is to more fully employ assets and to find more economical ways to acquire control of assets to improve their turnover ratio.
4. Interest Expense Ratio
A second critical financial efficiency measure is the interest expense ratio, which is found by dividing total farm interest expense by gross farm revenues. Generally, the interest expense ratio needs to be less than 25% for a profitable operation. An interest expense ratio above 25% may indicate the operation is carrying a heavier debt load than it can sustain.
5. Operating Profit Ratio
Profitability is the degree to which a business or activity yields financial gain. There are many profitability ratios that guide management in measuring their capital with the goal of generating a profit to cover family living expenses, build equity, and service debt.
The primary ratio for measuring profitability is the operating profit margin ratio:
Net income from operation + interest expenses − family living & partner draws
Gross farm revenue − land rents
The higher the rate, the higher return per dollar of gross revenue. The higher the ratio, the more of the value of farm production is available to pay interest and term debt and to purchase capital. A ratio of .35 or higher is generally preferred.
6. Equity to Asset Ratio
Solvency is the possession of assets in excess of liabilities. It is the ability to meet one’s debt obligation in the event you quit business; it indicates who truly “owns” the business. The equity to asset ratio is one measure of solvency. This ratio is calculated by dividing total equity by total assets. The higher the ratio, the more total capital has been supported by owners rather than creditors. A ratio of .40 or higher is generally preferred.
These are only 6 of the 16 financial measures that your farm operation should consider. The desired ranges indicated for each measure above are general guidelines. Crop insurance or the use of other risk management tools may change what a lender considers adequate.
Agricultural producers in the lower end of the ratio goals will feel financial stress first as margins tighten, while agricultural producers with ratios that fall more comfortably within these guidelines tend to have the staying power to weather the downturns. Financial ratios measure your progress over time, so make sure you're meeting your lender’s requirements and benchmark yourself against your peers.
If you need some help, the expert consultants at AgriSolutions can guide you in defining your current situation and specific needs for your farm business. Our goal is to help you get a better handle on how to implement best management practices in your agriculture business. Click below to request a free consultation, and learn about ways you can improve your farm operation.