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Special Financial Management Insert

Financial Benchmarking
From The Balance Sheet
From The Income Statement
From The Cash-Flow Statement
From All The Financial Statements
Farm Finance Scorecard

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Financial management is an important aspect of the farm business. The USDA and the American Agricultural Economics Association jointly formed a Farm Financial Standards Task Force to help producers and agribusiness identify crucial financial measures for evaluation of the operation. This task force condensed over 200 commonly used financial ratios into 16 critical financial ratios. These ratios use annual balance sheet, income statement, and cash flow statements to arrive at these financial ratios. More importantly, the task force set forth benchmarks for each of the 16 financial ratios for producers and agribusiness to use in ranking the financial condition of their operation. The 16 financial ratios and their description are listed below. Additionally, the final table lists ranges indicating financial strength and weakness for each financial ratio. An individual operator can calculate these ratios, or have their accountant calculate the ratios. Moving from left to right on the financial scorecard indicates moving from a relative level of weak financial performance to a relative level of strong financial performance.

(Author: by: Joe Parcell, Assistant Professor and Extension Economist

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From The Balance Sheet

Liquidity:  is the ability of your farm or business to meet financial obligations as they come due – to generate enough cash to pay your family living expenses and taxes, and make debt payments on time.

• Current Ratio: measures the extent to which current farm assets, if sold tomorrow, would pay off current farm liabilities.

• Working Capital:  tells us the operating capital available in the short term from within the business.

Solvency:  is the ability of your business to pay all of its debts if it were sold tomorrow. Solvency is important in evaluating the financial risk and borrowing capacity of the business.

Farm Debt-to-Asset Ratio: is the bank’s share of the business. It compares total farm debt to total farm assets. A higher ratio is an indicator of greater financial risk and lower borrowing capacity.

= Total farm liabilities / Total farm assets

Farm Equity-to-Asset Ratio:   is your share of the business, It compares farm equity to total farm assets. If you add the debt-to-asset ratio and the equity-to-asset ratio you must get 100%

= Farm net worth / Total farm assets

Farm Debt-to-Equity Ratio:   compares the bank’s ownership to your ownership. It also indicates how much the owners have leveraged (i.e., multiplied) their equity in the business.

= Total farm liabilities / Farm net worth

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From The Income Statement

Profitability:  is the difference between the value of goods produced and the cost of the resources used in their production.

Net Farm Income:  represents return to 3 things:

• your labor
• your management and
• your equity,  that you have invested in the business. It is the reward for investing your unpaid family labor, management and money in the business instead of elsewhere. Anything left in the business (i.e., not taken out for family living and taxes) will increase you farm net worth next year.

= Gross cash farm income – Total cash farm expense + Inventory changes +
Depreciation and other capital adjustments

Rate of Return on Farm Assets:  can be thought of as the average interest rate being earned on all(yours’ and creditors’) investments in the farm. Unpaid labor and management are assigned a return efore return on assets is calculated.

= (Accrual Net farm income + Interest Expense – Unpaid family labor)
/ Average farm assets

Rate of Return on Farm Equity: represents the interest rate being earned by your investment in the farm. This return can be compared to returns available if your equity were invested somewhere else, such as a certificate of deposit.

= (Accrual Net farm income – Value of operator’s labor and management)
/ Average farm net worth

Operating Profit Margin Ratio: shows the operating efficiency of the business. For instance, if expenses are low relative to the production, the business will have a healthy operating profit margin. A low profit margin can be caused by low product prices, high operating expenses, of inefficient production.

= (Accrual net farm income + Interest expense –
Unpaid Family Labor) / Gross farm revenue

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Repayment Capacity:   shows the borrower’s (i.e., your) ability to repay term debts (both farm and non-farm) on time. It includes non-farm income and so is not a measure of business performance alone.

Term-Debt Coverage Ratio:  tells whether your business produced enough cash to cover all (both farm and non-farm) intermediate and long-term debt payments. A ratio of less than 100% indicates that a business has run up open accounts, borrowed money, or sold assets to make scheduled payments to the bank.

= (Net farm operating income + Net non-farm income + Scheduled interest on term debt – Family living & taxes paid) / Scheduled principle payments on term debt

Capital-Replacement Margin: is the amount of money remaining after all operating expenses, taxes, family living costs and scheduled debt payments have been made. It is really the money left, after paying bills, that is available for purchasing or financing new machinery, equipment, land or livestock.

= Net farm operating income + Net non-farm income – Family living & taxes paid - Scheduled principle payments on term debt

Financial Efficiency:  shows how effectively your business uses assets to generate income. Past performance of the business could well indicate potential future accomplishments.

It also questions:

• Are you using every available asset to its fullest potential?
• What are the effects of production, purchasing, pricing, financing and marketing decisions on gross income?
• Asset Turnover Rate: measures efficiency in using capital. You could think of it as capital productivity.

• Generating a high level of production with a low level of capital investment will give a high asset-turnover rate. If, on the other hand, the turnover is so low you will want to explore methods to use the capital invested much more efficiently or sell some low-return investments.
• The last four ratios show how Gross Farm Income gets spent. The sum of the four equals 100% of Gross Farm Income.

= Gross farm income / Total farm assets

Operating-Expense Ratio: shows the proportion of farm income that is used to pay operating expenses, not including principle or interest.

=(Total farm operating expense – Depreciation – Farm interest) / Gross farm income

Depreciation-Expense Ratio: indicates how fast the business wears out capital. It tells what proportion of farm income is needed to maintain the capital used by the business. It is important to remember that this ratio should be looked at over time. This measure is likely to be misleading during major expansions and contractions, or if you use depreciation on your 1040F to adjust your tax liability.

= Depreciation & other capital adjustments / Gross farm income

Interest-Expense Ratio:   shows how much of gross farm income is used to pay for borrowed capital.

= Farm interest / Gross farm income

Net Farm Income Ratio:  compares profit to gross farm income. It shows how much is left after all farm expenses, except for unpaid labor and management, are paid.

=Accrual net farm income / Gross farm income

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Click here for Farm Finance Scorecard

Ag Connection - November 1999 Insert
http://outreach.missouri.edu/agconnection/newsletters/is-99-11-insert.htm -- Revised: April 20, 2004
daydr@missouri.edu