Financial Record-Keeping - Level 3

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This Level 3 Financial Record-Keeping module has been designed to build upon the modules covered in Financial Record-Keeping Level 1 and Level 2. These modules are designed to be used by a wide range of producers and management systems. The purpose of Level 3 is to dig deeper into analysis and application of collected farm data.

In agriculture there are many areas of risk and uncertainty. Sectors with tight margins, such as the beef sector, can greatly benefit from having a better understanding of their operation’s finances. Understanding strengths and weaknesses is one way to reduce the stress that comes with uncertainty and provide financial resiliency to help an operation adapt to challenges.

Farms often have to make quick financial decisions impacted by weather or other outside variables. Knowing one’s financial ratios gives options as they can represent possibilities and flexibility for the operation in how they respond. Farm businesses should have a good working relationship with their financial institutions, whether they are leveraged or not, as those quick decisions can be smoother with an existing creditor relationship.

Financial ratios can be used to analyze an operation over time. Financial ratios do not provide the answers as to why a business is performing well or underperforming, although they can help point out the areas to examine in order to ask the right questions about the business. They can help identify an operation’s areas of financial risk (stress); and assist in making decisions that affect these numbers. Remember, these ratios represent a point in time and will change depending on the year (e.g. markets, prices of inputs and outputs).

In addition to comparing a business’ historical performance, there are general guidelines that can be used to see how that business compares to an industry ratio range provided (see Table 2).  It should be noted that financial ratios will vary by sector and industry. Some ratios are less effective for comparing operations of different sizes.  

Table 2. Farm Financial Ratios

*There is no recommended metric for profitability as this will vary depending on farm size.

Every operation will be different, some will have short-term debt, others will have long-term debt. Some will be leveraged with a bank more heavily while others utilize internal equity. These choices are as varied as the types of operations found from coast to coast. It should be noted that having a single ratio in the red is not necessarily bad. You cannot look at a single ratio and determine the overall health of a business or farming operation. Multiple ratios must be used along with other information to determine the total and overall economic health of a farming operation and business.

Start by completing a balance sheet and income statement every year-end. As mentioned in Level 2, the balance sheet identifies your business assets, liabilities, and equity. Once these financial statements are completed, there are several financial management measurements that can be calculated. These can be calculated with both cash and accrual statements, whatever you are using.

Liquidity

Taking on more debt to finance the purchase of assets allows a business to expand and grow. Paying off the debt is done with the additional revenues generated by properly deploying these assets. Reducing debt or seeing assets gain value over time are two ways to build equity or net worth. However, financing a large portion of the business growth through debt also exposes a business to financial risk⁷. Monitoring financial ratios around liquidity and solvency can inform you about how much financial risk the operation has taken on.

Liquidity addresses an operation’s ability to meet short-term debts; while solvency addresses an operation’s ability to meet long-term debts. They are used both independently and together.

Data to use: Financial ratios can be calculated by pulling numbers from the balance sheet and income statement. The balance sheet often reports assets and liabilities as current (less than 12 months), intermediate (1-10 years) and long term (more than 10 years) which includes land, buildings, mortgages, and longer-term loans. Intermediate is frequently included with long-term.

Quick Ratio or Acid Test

Quick Ratio = Cash Equivalents / Current Liabilities

The Quick Ratio is a measure of the proportion of cash (or cash equivalents) to current liabilities.  Unlike the current ratio, the quick ratio does not include inventories and assets which disrupt normal business operations when converted to cash.

The Quick Ratio is important as it shows if producers can pay off their current liabilities (over the next 12 months) without selling breeding cattle, yearlings, hay, or other commodities that will be produced over the next twelve months.

Working Capital

Working Capital = (Current Assets – Current Liabilities) / Annual Expenses

Working capital is a theoretical measure of the amount of funds available to purchase inputs and inventory items after the sale of current assets and payment of all current liabilities. A ratio of 0.5 means that one has enough working capital on hand to cover approximately 6 months’ worth of expenses.

If working capital is the first line of defence in paying short-term debt, not having access to capital can force an operation into secondary means of repayment (refinancing of debt) or possibly even selling assets⁹. The amount of working capital considered adequate must be related to the size of the farm business.

Solvency

Solvency ratios include financial obligations in both the long and short term and measures an operation’s ability to meet those obligations. Solvency ratios assess long-term economic health by evaluating repayment ability for long-term debt and interest on that debt.

Debt to Asset Ratio

Debt to Asset ratio = Total Liabilities / Total Assets

The Debt to Asset Ratio shows the portion of total assets financed through debt. This ratio is a measure of the extent of creditor financing used by the business. The higher the value of the ratio, the higher the financial risk. A lower debt to asset ratio brings flexibility to an operation if it must withstand challenges or be able to seize opportunities quickly (e.g. expansion, diversification).

It can be calculated by using either the cost or market value approach to value assets. The ratio is most meaningful for comparing between farms when market value is used. But due to market fluctuations, the cost approach is most meaningful for year over year comparisons on the same farm.

Equity to Asset Ratio

Equity to Asset Ratio = Total Equity / Total Assets

The Equity to Asset Ratio is a measure of the extent of leverage being used by the business.  It considers the proportion of total assets paid by the owners’ equity versus those financed by creditors.  The higher the ratio means more total capital has been supplied by the owners, and less by creditors and, in most cases, the business is more solvent, and better equipped to pay its debts.

Debt to Equity Ratio

Debt to Equity Ratio = Total Liabilities / Total Equity

The Debt to Equity Ratio indicates the ability of equity to cover all outstanding debt which includes both short term and long-term obligations. A low debt-to-equity ratio provides flexibility to extend terms on existing debt when profits and repayment capacity are tighter and to borrow more money if an opportunity arises¹². In contrast, the higher the ratio, the more total capital has been supplied by the creditors and less by the owners.

These ratios will vary depending upon management and efficiencies of the operation. Feeding operations typically are more leveraged with a higher proportion of debt in current liabilities to finance feeder cattle.

Profitability

A farm business has three ways to increase profits — by increasing the value per unit sold, decreasing the cost per unit produced or increasing the volume produced.

Profitability measures that are universally accepted for their value to management include: return on assets, return on equity, and operating profit margin. They measure the extent to which a business generates net income or profit from the use of its resources. Technically, they are efficiency metrics that measure the relationship between an output, in this case net farm income from operations, and an input.⁷ However, when evaluating the strength of a loan request, profitability measures can create distracting noise, which is not helpful in a lending discussion.

The Return on Assets may seem low when compared to non-farm investments such as stocks and bonds. It should be recognized that neither realized nor unrealized gains on farm real estate and other assets are included as income.

The value of the ratio can vary with the structural characteristics of the farm business, especially with the proportion of owned land (or other assets) used in the farming operation. A higher ratio is an indication of greater profits and ability to leverage assets to create a profit.

Return on Equity (ROE)

Return on Equity = Income / Total Equity

The Return on Equity is used as an overall index of profitability. Income is calculated after interest, owner withdrawal for unpaid labour and management have been removed, but before taxes. Deferred taxes should be included in the total equity calculation.

Caution should be used when interpreting this ratio. A high ratio, normally associated with a profitable farm business, may also indicate an undercapitalized or highly leveraged farm business. A low ratio, which normally indicates an unprofitable farm business, may also indicate a more conservative, high equity farm business. This measure, like many of the other ratios, should be used in conjunction with other ratios when analyzing a farm business.

Operating Profit Margin Ratio

Operating Profit Margin Ratio = Income – owner withdrawal for unpaid labour and management / Revenues

This ratio measures profitability in terms of return per dollar of revenue. Each farm will have a made a decision about paid labour, unpaid labour and owner withdrawal that will show up on the balance sheet and income statements used to calculate these ratios. The Operating Profit Margin Ratio shows what the owner is withdrawing to live on if anything.

Net Income

Net Income (before income tax) = Total Revenue – Total Expenses (before income tax)

Net Income is the return to the producer for unpaid labour, management, and owner equity. The measure is a dollar amount (which may be positive or negative); therefore, it is difficult to compare across farm businesses. You may find it easier to compare from year to year by making an accrual adjustment (If the income statement is prepared using cash accounting, then both beginning and ending balance sheets are needed to make the necessary adjustments for changes in inventories, accounts receivable, accounts payable, prepaid expenses and accrued expenses).

Repayment Capacity

The two main measures to assess an operation’s debt repayment capacity are its balance sheet and cash flow measures. By analyzing key metrics from the balance sheet and cash flow statements, creditors determine the amount of sustainable debt a company can handle.

Debt Payout Ratio

Debt Payout Ratio = Total Liabilities / Net Income

The Debt Payout Ratio shows how many years are required to pay all the debts through net returns. A lower number indicates it will take the operator less time to pay down debt. Remember that land mortgages are typically amortized over 20, 25, or 30 years.

This number will reflect where an operation is in its lifespan; a new operation will have more debt with a higher ratio and a mature operation with a retirement plan will have a lower ratio. Operations in the process of succession planning will vary based on the stage and situation (e.g. if they are expanding).

Data to use: Everything up to this point can be calculated by pulling numbers from the balance sheet and income statement. For this ratio, start by calculating your Net Income, as shown in the Profitability section.

Debt Service Coverage Ratio (DSCR)

Debt Service Coverage Ratio = Income / Debt Service

The Debt Service Coverage Ratio (DSCR) measures an operation’s cash flow available to service debt. This is used by banks to assess the customers’ capacity to repay their existing long-term loans and take on new long-term loans.

A DSCR of 1.5 indicates an operation has 1.5 times more cash available to pay current debt obligations than the total amount owing. A ratio below 1 indicates an inability to rely on net cash income and off-farm income to service debt. 

If a DSCR is too low, a farm may find it hard to make payments on what is owed using only revenues. A very high DSC may not be optimal either. While it can reflect an operation that does not need debt to generate revenue, it may also point to one that is not exploiting market opportunities.

Scenarios can be conducted to assess how a reduction in revenue, or increase in production costs, or variable expenses will affect the debt service coverage ratio.

Financial Efficiency

Financial efficiency is all about getting more output from the same resources or getting the same output from fewer resources. There are efficiency ratios used to measure either production or financial efficiency, or a combination of both.

Asset Turnover Ratio

Asset Turnover Ratio = Total Revenue / Total Assets

Operating Expense Ratio

Operating Expense Ratio = Operating Expenses / Total Revenue

Data to use: From the income statement use the variable (aka operating) expenses. Variable expenses include daily operational expenses (labour, feed, crop protection, fuel, maintenance, insurance, repairs, and service provider fees, for example). Loan payments, depreciation, and capital improvements are excluded from operating expenses⁸.

Example

Example farms are provided utilizing the sample Financial Statements (see the linked Balance Sheet and Income Statement for details). The ratios presented in Table 3 are calculated from these financial statements.

Table 3. Sample Farm Financial Ratios

Farm ABC has chosen to put cash into inventory, reflected in the large operating expenses as a percentage of total expenses. It is an indication they are purchasing all their feed and have large animal purchases.

Farm MNO has chosen to keep cash on hand versus investing in long-term assets. The current year has more liabilities making it a year to pay off loans, but these loans could be what is making them appear profitable. This means they will have to monitor cash flow carefully throughout the year. While working capital is negative, net income is positive and they have cash on hand. This is why it is important to look at multiple financial indicators and any single indicator in isolation. This also means that next year they could be significantly improved. They are heavily leveraged, and currently have a small amount of equity so they have a smaller return on equity.

Farm XYZ is a farm with land mortgages showing up in the long-term debt. The majority of the land is rented out, but they are farming a portion of the land. However, this was a poor production year as cash and inventories are low. The debt payout ratio is negative while the debt service coverage ratio indicates that off-farm income is being used to make debt service payments.

Gross Margin Ratio

Gross Margin Ratio = Income from enterprise X / Variable expenses from enterprise X

Gross Margins provide a method of comparing the performance of each enterprise. A gross margin refers to the total income derived from an enterprise less the variable costs incurred in the enterprise.

Variable expenses (or operating expenses) include feed, crop protection, fuel, maintenance, insurance, repairs, and service provider fees. Loan payments, depreciation, and capital improvements are excluded from operating expenses⁸.

Producers must choose which enterprise each of these variable expenses apply to. The benefit of the gross margin ratio is the fact that you do not have to allocate fixed/overhead costs to each enterprise. These fixed costs are assumed to be part of the operation and gross margin ratios help find which enterprise will contribute the most to covering their costs. However, when an operation has fixed costs that are strongly associated with a single enterprise the gross margin analysis can be misleading. Therefore, capital and labour which are excluded from the gross margin ratios need to be taken into consideration prior to making concrete decisions.

Data to use: Variable costs allocated to each enterprise and income generated from each enterprise.

Scenario: Farm A is considering hiring a custom silage crew, instead of haying with owned equipment. The decision must consider that additional cash expenses will be incurred with custom silage; while it will reduce labour requirements. At the same time, the farm will continue to have the cost of owning the haying equipment.

Farm B is considering using a community pasture when they have deeded land to pay and utilize. They are prioritizing winter feed production on their deeded land. The decision must consider the additional cost of community pasture fees and how expensive that makes the winter feed production. 

Farm C is considering buying more cattle to utilize all of their own land and available community pasture for summer grazing. This would mean they would have to buy 100% of their winter feed. If they do not buy their winter feed, they would have to sell their cattle herd. The decision must consider the additional cost of the community pasture and purchasing winter feed with the increase in revenue from a larger cattle herd.

Farm D is considering selling some of their cattle while utilizing the community pasture for their summer grazing. They would use their own equipment and owned land to put up winter feed so that they do not have to buy any winter feed (it would be 100% homegrown). The decision must consider labour availability to grow 100% of their winter feed and understanding that the short-term decision to sell cattle will result in less income next year. 

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