Liquidity is the ability of your farm business to meet
financial obligations as they come due, to pay family living expenses
and taxes and make debt payments. The ratios measuring liquidity are
calculated from the balance sheet and include:
- Current ratio - is the ratio of current assets to current
liabilities. It measures the extent to which current farm assets, if
sold tomorrow, would pay off current farm liabilities.
- Working capital - indicates the amount of working capital for
the short term from the business. Working capital is the difference
between current assets and current liabilities.
Solvency is the ability of your business to pay all its
debts if it were sold tomorrow. Solvency is important in evaluating
the financial risk and borrowing capacity of the business. These
ratios are calculated from the balance sheet and include:
- Farm debt-to-asset ratio - is the lender’s share of the
business. It compares total farm debt to the total value of farm
assets. The higher the ratio the greater the financial risk and the
lower the borrowing capacity.
- Farm equity-to-asset ratio - is your share of the business.
It compares farm equity to the total value of farm assets. Adding
the debt-to-asset ratio and the equity-to-asset ratio must equal
100%.
- Farm debt-to-equity ratio - compares the lender’s
ownership of the business to your ownership. It also indicates how
much the owner(s) have leveraged the equity in the
business.
Profitability is the difference between the value
of goods produced and the cost of the resources used in their
production. Over time, profits drive the liquidity and solvency of a
farm business. Without adequate profits, future growth in net worth
from the farm operations is not possible. The following
profitability measures come from the income statement:
- Net farm income - represents a return to unpaid labor and
management and equity invested in the business. Any net farm income
not withdrawn from the business for family living and taxes is
retained earnings and increases your farm net worth.
- Rate of return on farm assets - is the average interest rate
earned on the total investment in the farm business. Unpaid labor
and management are assigned a value before the return on total farm
assets is calculated.
- Rate of return on farm equity - is the interest rate being
earned on your equity investment in the farm. This return can be
compared to returns available if your equity were in alternative
investments with a comparable risk.
- Operating profit margin - shows how effectively funds are
spent on operating expenses to generate business income. If the
operating expenses are low relative to the value of farm production,
the business will have a good operating margin. A low profit margin
can be caused by low product prices, high operating expenses or
inefficient production.
Repayment capacity shows your
ability to repay all term debts on a timely basis. Repayment
capacity includes non-farm income and is not a measure of business
performance alone. These ratios and measures come from the cash flow
statement and are:
- Term debt coverage ratio - tells whether your business
generated enough cash to cover all (farm and non-farm) intermediate
and long term debt payments. A ratio less than 100% indicates that
the business had to run up open accounts, borrow money or sell
assets to meet scheduled loan payments.
- 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 represents the money
available for purchasing or financing new capital assets or paying
off additional debt.
Financial efficiency - shows how
effectively your business uses assets to generate income. Financial
efficiency ratios help answer the questions - is each asset being
used to the fullest potential? and what are the effects of
production, pricing, financing and marketing decisions on gross
income?
- Asset-turnover ratio - measures capital productivity or
capital efficiency. Generating a high level of production with low
capital investment will give a high asset-turnover ratio. If the
turnover is low, you will want to consider alternatives to use
capital invested more efficiently or sell low return
investments.
- Operating expense ratio - shows the proportion of gross farm
income used to pay operating expenses, not including depreciation
and interest.
- Depreciation expense ratio - indicates how fast the business
wears out capital assets and what proportion of gross farm income is
needed to maintain the capital used in the business. This ratio
should be looked at over time since it can be misleading during
major expansions or contractions or if you use depreciation from
Schedule F.
- Interest expense ratio - shows what percentage of gross farm
income is used to pay for the use of borrowed capital.
- Net farm income ratio - compares net farm income (profit) to
gross income. It shows what percentage of gross farm income is left
after all farm expenses are paid.
