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Understanding Key Financial Ratios and Benchmarks

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Understanding Key Financial Ratios and Benchmarks Understanding Key Financial Ratios and Benchmarks How does my business stack up compared to my neighbors? This question is becoming more and more common as the agricultural industry continues to change and evolve. The exciting opportunities arising in agriculture are not without challenges that will separate the leaders and the followers in the industry. The changing and expanding domestic and export markets will place greater importance on decisions made in finance, marketing, and management. The use of financial ratios and benchmarks will provide agricultural businesses with a means of evaluating performance and success. Who uses financial ratios and benchmark data, and why? Financial ratios and benchmarks are useful for persons both inside and outside a business. Management can use the information to assist in decision-making and goal setting and to compare their business performance to that of similar operations. Lenders and other creditors can use the same information to evaluate credit risk. Calculating financial ratios at regular intervals increased use of financial ratios and helps all involved to measure progress over benchmarks in agriculture. First, the Farm time. Ratios can help identify symptoms of Financial Standards Council established underlying problems in a business and help universally-recognized measures of management focus its attention where it financial performance. This enables a wheat is most needed. Objective measures also producer in Washington to be analyzed decrease the likelihood decisions will be made using the same ratios as a cotton farmer solely on an intuitive or emotional basis. in Virginia, although the interpretation may be slightly different. This consistency Where can you obtain marked a substantial step in the evolution of benchmark data? financial ratio analysis in agriculture. Second, producers are maintaining better records, Financial ratios are of little use without thus improving the accuracy and reliability benchmarks to compare them against. of available data. Third, lenders are requiring Benchmarks are guidelines or general rules better information to evaluate credit quality of thumb related to a specific industry and improve their understanding of their or business segment. As benchmarking customers’ operations. and ratio analysis continue to grow in popularity, the availability of such data The Farm Financial Standards Council will also improve. Various public and identified the following five critical areas for private organizations collect and analyze analyzing financial performance: financial data on the agricultural industry as a whole and on specific sectors. Often • Repayment ability or capacity this information is available to the general • Liquidity public. Ratio guidelines for general agriculture, retail, wholesale, service, and • Solvency and collateral manufacturing firms are available through sources such as the Risk Management • Profitability Association. Support institutions, such as • Financial efficiency agricultural lenders, often provide this information at little or no cost. Within these five areas, the council identified key ratios for evaluation. In the table on Why have financial ratios and page 12, the calculations for each ratio are benchmarks become popular in detailed and the correlating benchmarks agriculture? are presented in terms of green, yellow and red lights. A green light represents low risk, Three factors have contributed to the a yellow light corresponds to moderate risk, 2 © 2008 Northwest Farm Credit Services, Spokane, WA. All Rights Reserved. Reproduced with permission only. Understanding Key Financial BUSINESS TOOLS Ratios and Benchmarks and a red light means high risk. A green light doesn’t guarantee success, nor does a red light imply failure. A weakness in one area may be overcome by strengths in other areas. Variations may occur between industries. While the ratios are very interrelated, there are subtleties to interpretation that must be considered. Some ratios are measured at a single point in time, which varies depending upon the particular point in the production cycle. Others encompass a certain time period or an entire operating cycle. As such, trends become important in understanding the relative progress of an operation. Repayment Analysis Repayment capacity is the ability of a business to support a living, meet all expenses and debt payments, replace depreciating capital assets, and prepare for the future through business investments and retirement plans. Term debt and lease coverage ratio Repayment analysis is comparing capacity to requirement. Or, comparing earnings available to meet debt obligations to the light. A ratio between 110 percent and 150 total of annual debt payments and capital percent is acceptable, but riskier, and is a investments. A benchmark used to examine yellow light. A ratio less than 110 percent is repayment ability is the term debt and lease a high risk and a red light. A business with a coverage ratio. Exhibit 1 shows the data ratio in the red zone or showing a declining needed and procedure used to calculate the trend should take immediate measures to ratio. Experience indicates the greater the remedy the situation. net earnings to cover debt payments, the easier an operation can handle unforeseen To protect against adversity, or to provide expenses, lowering the risk. Thus, a ratio for unexpected opportunities, an operation greater than 150 percent is a low risk, or green needs a margin to cover debt payments. 3 The relative level required may change depreciation and a large margin may indicate depending on the needs of the business. deferred maintenance on the machinery line. A business that is expanding or making Finally, the amount of government payments major capital adjustments should have a can be compared to the margin to assess the minimum coverage ratio of 150 percent. dependence on support payments. This accounts for cost overruns or problems in production or marketing. On the other Debt payment/income ratio hand, an operation with a smaller repayment A second ratio measuring repayment margin is acceptable if loans are structured capacity is the debt payment/income ratio, with fixed rates or non-farm employment, which measures the ability of a business to living expenses and income tax payments are service debt over the term of a loan. This is steady, and the operation is stable. However, calculated by dividing total debt payments the lower the coverage ratio, the more by the adjusted farm and non-farm income important risk management tools become, figure (Exhibit 1, line 11). Since a heavier such as crop and property insurances, liquidity, debt burden reduces an operation’s hedging, options, or contracted production. flexibility and increases risk, a ratio of less than 25 percent would be a green light, a Capital replacement and term debt ratio of 25 percent to 50 percent would be repayment margin a yellow light, and anything over 50 percent Another measure derived during repayment would be considered high risk or a red light. analysis is the capital replacement and term debt repayment margin found on the Strategies to improve repayment capacity previous page (Exhibit 1, line 10). This is the ratios are: difference between capacity and payments. • Increase net farm income through: This margin is useful for analyzing several factors. For instance, the significance of non- - Improved quality, price, or amount of farm income can be measured by comparing production the level of non-farm revenue to the margin. - More effective marketing If the margin approaches zero or is negative Sale of capital assets (short-run strategy) when net farm income is deducted, this - indicates a heavy reliance on outside sources • Reduce operating expenses of repayment. The margin should also be compared to annual depreciation expense. • Increase off-farm earnings If depreciation is greater than the margin, • Closely monitor family living withdrawals it may indicate insufficient capacity to and reduce if necessary replace capital assets such as machinery and equipment. Conversely, a small amount of • Restructure debt 4 Understanding Key Financial BUSINESS TOOLS Ratios and Benchmarks Liquidity Analysis Liquidity is defined as the availability of cash and near-cash assets to cover short- term obligations without disrupting normal business operations. Current ratio The most common measure of liquidity is the current ratio, which is calculated by dividing current assets by current liabilities (Exhibit 2). Generally, a ratio greater than 1.50 is considered a green light, between 1.00 and 1.50 a yellow light, and less than 1.00 a red light. However, several factors, Working capital including the type of operation, can A second common measure of liquidity impact the current ratio. For instance, dairy is working capital, which is simply the producers and similar operations carrying difference between current assets and low inventories and having stable monthly current liabilities (Exhibit 2). Working capital incomes can manage with a lower ratio. is the owner’s share of the production assets. However, operations with high inventories Because this is an absolute measure rather and accounts receivable require a higher than a ratio, no one level of working capital ratio. Since this ratio is measured at a single is preferred. However, as working capital point in time, the ratio will vary depending increases, the flexibility a business has in upon the point in the production cycle. marketing, acquiring capital assets,
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