SOH CAH TOA. Perhaps you had some exposure to trigonometry in your high school math class. To recall, it is a tool to help remember how three legs of a right triangle could be set as ratios – three of which had the names Sine, Cosine, and Tangent. Like a right triangle has three sides, a Balance Sheet has categories – Assets, Liabilities and Equities. And like SOH CAH TOA, bankers and financial analysts will present a confusing array of the six ratios that can be formed from these three numbers. Equity/Assets, Debt/Equity, Debt/Assets and (less so) Assets/Equity, Assets/Debt and Equity/Debt.
Because Equity is always Assets minus Liabilities, the use of different ratios only serves to confuse the lay person. Do not be that confused person. Always think in terms of Equity/Assets. None of the ratios convey any more or less information that the others. And Equity/Assets is the most intuitive for the business owner. This ratio tells you what portion of all the stuff (the assets) belongs to you – it is understood that your lender owns the balance.
This ratio is the most important ratio of all. It is the ratio that tells you when the bank will force you out of the game. For farms, when you have Equity/Assets = 0.30 expect to be asked a question like, “Have you thought about retiring?” or “Maybe you should see if any other lenders can help you out this year?” If such a simple ratio is so important, maybe you should pay close attention to it.
The ratio, like any ratio, is easy to calculate. It is just the top number (numerator) divided by the bottom number (denominator). If you do this on your calculator, never let the answer be less than 0.40! This gives you a cushion, because the ratio can vary based on market forces outside of your control. And you need to be in control.
Let’s talk about the bottom number or denominator. This is the Total Assets of the business. That sounds like an easy number to identify, but it is not that simple. If you have multiple entities (more than one business or separate companies that comprise your business), you will need to consolidate them into one financial report. This requires you to eliminate inter-company activity like where one entity has loans outstanding with another one of your businesses or where one of the entities shows up as an asset in one of the other entities. Those must be removed to avoid confusing the ratios.
Your Total Assets
In addition, Total Assets for the consolidated business needs to be valued at fair-market value. Be honest as you are not able to really fool any body and you certainly don’t want to fool yourself. For the land, the equipment, the grain, the herds, the inventories, and more, record the amounts at what they are reasonable worth on the open market. Do this on the same day every year – the last day of your fiscal calendar. This is the Total Assets number we want for the bottom number of our ratio.
To get the top number you first have to add up all the money you owe to everyone. This includes the large structured long-term loans, but it also includes the money you owe vendors and the government. Don’t forget about the interest due on your operating note. Once you have your Total Liabilities, your Total Equity (the number we will put in the numerator) is simply Total Assets minus Total Liabilities. Remember Total Equity divided by Total Assets should be greater than 0.40.
At AgriSolutions, we target 0.60 for the Equity/Asset ratio. Our logic is that it makes sense to own the majority of your business. If your balance sheet is too leveraged, (i.e. .30 Equity/Asset Ratio), a mistake or market shock could result in a significant issue for the future of your business as well as your access to capital. If you need help in assembling these numbers, understanding your financial situation or developing a plan to improve your situation, AgriSolutions can help.
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