By Courtney Bir, Rodney Jones, Brent Ladd Show
Measures of financial performance reduce a large amount of information into a convenient form for analysis. No single measure of financial performance is adequate for evaluating a farm business. Evaluation of several financial measures may be more useful in directing the manager to ask the right questions than in providing solutions to the financial problems of the business. Both the magnitude of the measure and its relationship to other measures should be evaluated. Decisions made in developing the balance sheet, cash flow statement, and income statement have important impacts on the financial measures discussed in this OSU Extension Fact Sheet. Some of those decisions include using cost or market values in preparing the balance sheet; determining a specific value for each asset and liability on the balance sheet; including or excluding accrued expenses, deferred taxes, and personal assets and liabilities from the balance sheet; estimating net income on a cash, accrual, or accrual adjusted basis; and deciding if income should be before or after taxes. Each of these decisions affects key relationships in the financial statements and impacts the financial measures used to evaluate financial performance and position. The overall performance and position of the business should be evaluated based on a set of criteria that includes liquidity, solvency, profitability, financial efficiency, and repayment capacity. Each of these criteria measures a different aspect of financial performance and/or position.
Solvency measures the ability of the firm to pay all debts if the assets of the business are sold. Generally, if the market value of total assets exceeds existing debt obligations against those assets, the business is solvent.
Repayment capacity measures the ability of the business to repay existing debt commitments from farm and nonfarm income, and it is closely related to the concept of liquidity. Each of these criteria plays an important role in the analysis of financial performance and position of a business, and each has alternative measures that are discussed in this OSU Fact Sheet. Measuring LiquidityLiquidity is the ability to generate cash to meet cash demands as they occur during the year and to provide for unanticipated events. Cash is needed to pay for the usual expenses of the business, including operating expenses, capital items, and scheduled debt payments, and provide for personal transactions, such as family living expenses. Unanticipated events, such as adverse weather or price conditions, which produce economic losses, or new investment opportunities, may make it difficult to meet cash demands. Current RatioThe two balance sheet measures most often used to evaluate liquidity are the current ratio and working capital. The current ratio is used to evaluate liquidity through the relationship between current farm assets and current farm liabilities. However, the current ratio is a relative measure rather than an absolute dollar measure. It is calculated as follows: Total current farm assets ÷ Total current farm liabilities Current farm assets normally include cash, marketable securities, accounts receivable, and inventories. Current farm liabilities include accounts and short-term notes payable, interest and principal payments on long-term debt, accrued income taxes, and other accrued expenses. The ratio indicates the extent to which current farm assets, if liquidated, would cover current farm liabilities. If the ratio is greater than 1.0, the farm is considered liquid. The higher the ratio, the greater the liquidity. If less than 1.0, the farm is considered not liquid, indicating some degree of cash flow risk. A more careful evaluation of the cash flow statement would be appropriate, given this indication of a possible liquidity problem. A ratio between 1.0-2.0 should trigger further investigation and would be considered cautionary under the farm and ranch stress test guidelines. Based on data from the Madison’s market-based balance sheet which includes deferred taxes, the current ratio as of March 1 is: 341,536 ÷ 237,250=1.439 Including deferred taxes is a conservative approach to calculating the current ratio; however, it recognizes that if all current farm assets are sold during the next year, the deferred taxes would be owed. It is better for the producer and lender to be aware of the contingent liability and to determine its potential impact, than to ignore the tax implications of selling assets. Generally, lenders and analysts like to see a current ratio of 1.5 to 2.0, when using the market value approach, excluding deferred taxes. The Madison's current ratio is lower than desired by lenders in an evaluation of short-term or operating credit needs. If deferred taxes (63,817) were excluded in calculating the Madison’s current farm liabilities, the current ratio would be 1.969. The current ratio may register higher and lower, at different times during the year, for good reason.
Measuring SolvencySolvency relates primarily to the firm’s ability to meet long-term commitments as they come due. If the value of total farm assets exceeds total farm liabilities, the farm is said to be solvent; if the sale of all assets would not generate sufficient cash to pay off all liabilities, the farm is insolvent. The difference between the value of total assets and total liabilities, generally referred to as net worth or owner’s equity, is the most often used measure of solvency. The most realistic approach to calculating owner equity is to use the market-based approach to value assets, including consideration of deferred taxes. Three ratios are used to measure financial solvency: the equity-to-asset ratio, the debt-to-asset ratio, and the debt-to-equity or leverage ratio. Equity-to-Asset RatioThe equity-to-asset ratio indicates the proportion of total farm assets owned or financed by the owner’s equity capital. It is calculated by dividing total farm equity by total farm assets, as follows: Total farm equity ÷ Total farm assets = (Total farm assets – Total farm liabilities) ÷ Total farm assets [(Total current farm assets + Total non current farm assets) + (Total current farm liabilities + Total non current farm liabilities) - Total farm liabilities] ÷ (Total current farm assets + Total non current farm assets) The higher the equity-to-asset ratio, the more capital supplied by the farm owner and the less supplied by the creditors. There is no exact standard for the equity-to-asset ratio, which would apply to every farm business. However, as the percent equity increases above 50, the owner is supplying a greater percent of the total capital in the business than the creditors. With data from the Madison’s balance sheet, estimated using the market-value approach and including deferred taxes, the equity-to-asset ratio as of March 1 is: ($3,124,095 - $835,556) ÷ $3,124,095 = $2,228,539 ÷ $3,124,095 = 0.73 With an equity-to-asset ratio substantially above 50 percent, the Madison's are in a strong equity position. Also, this ratio should increase over time if the owner retains farm profits and reduces debt obligations.
Debt-to-Asset RatioThe debt-to-equity ratio is a third measure of solvency, and indicates the relative proportion of funds invested by creditors versus the farm owners. The higher the value of the debt-to-equity ratio, the more total capital supplied by the creditors relative to the farm owner. The debt-to-equity ratio is calculated by dividing total farm liabilities by total farm equity, as follows: Total farm liabilities ÷ Total farm equity = (Total current farm liabilities + Total noncurrent farm liabilities) ÷ (Total current farm assets + Total noncurrent farm assets) With data from the Madison’s balance sheet, estimated using the market-value approach and including deferred taxes, the debt-to-asset ratio as of March 1 is: ($237,250 + $598,306) ÷ ($341,536 +
$2,782,559) = Although there is no exact standard for every farm business, a debt-to-asset ratio greater than .50 indicates that less than 50 percent of the value of the farm’s total assets is contributed by owners. Faced with this situation, the creditors are likely to be cautious in advancing additional funds. The Madison’s debt-to-asset ratio of .26 indicates the creditors are contributing only about 26 percent of the farm assets.
Debt-to-Equity RatioThe debt-to-equity ratio is a third measure of solvency, and indicates the relative proportion of funds invested by creditors versus the farm owners. The higher the value of the debt-to-equity ratio, the more total capital supplied by the creditors relative to the farm owner. The debt-to-equity ratio is calculated by dividing total farm liabilities by total farm equity, as follows: Total farm liabilities ÷ Total farm equity =
This ratio is also referred to as the leverage ratio. Leverage refers to increasing the use of debt relative to equity as a means of financing the business. The higher the leverage ratio, the more total capital supplied by the creditors and the less by the farm owner. Lenders are particularly interested in this ratio because it shows the proportion of the risk they are taking in comparison to the owner. Many lenders prefer the debt-to-equity ratio to be less than 1.0, with requirements varying depending on whether the liabilities are secured by current, intermediate, or long-term assets. In general, the greater the loan risk and longer the loan terms, the lower the ratio desired by the lender. Using data from the Madison’s balance sheet, estimated using the market-value approach and including deferred taxes, the debt-to-equity ratio as of March 1 is:
$835,556 ÷ $2,288,539 = 0.36
Influence of Asset Valuation MethodAll three ratios are influenced by the value placed on farm assets. Market value more accurately represents the realizable value owners can receive for their assets. However, deferred taxes that would result from the sale of assets should be considered as liabilities (both current and noncurrent) in developing the solvency ratios. Using current market value without considering deferred taxes might suggest more “comfort” than exists. Also, when only the market-value approach to valuing assets is used, those evaluating solvency ratios need to consider the source(s) of the owner equity and identify how much came from contributed capital, changes in asset values, and retained earnings. It is important over time for equity to be earned through the operation and success of the business rather than from appreciation in asset values.
Measuring ProfitabilityProfitability measures the financial performance of the farm over a period of time, usually one year, as a result of decisions regarding use of land, labor, capital, and management resources. The five measures used to assess profitability are net farm income, net farm income from operations, rate of return on farm assets, rate of return on farm equity, and operating profit margin ratio. Net Farm Income from OperationsNet farm income from operations represents the return to unpaid operator and family labor and management, and the owner’s equity capital from the normal operation of the business. Net farm income from operations comes directly from the income statement, and is calculated by subtracting all farm operating expenses incurred to create those revenues. Changes in the values of inventories and capital items are reflected in net farm income from operations, but not the gain or loss resulting from the sale of farm capital items and marketable securities.
Net farm income from operations is a dollar amount and not a financial ratio. Thus, no one standard is appropriate for all farm operations or to make comparisons with other agricultural businesses. Net farm income from operations should be positive and sufficiently large to compensate the owner for utilizing his/her labor, management, and equity capital in the farming operation. Over time, profits should increase so funds can be allocated to farm capital replacement, nonfarm expenses, and retained earnings Net Farm IncomeNet farm income is net farm income from operations adjusted for the gain/loss resulting from the sale of farm capital items and marketable securities. The Madison’s net farm income, using the market-value approach, is $31,546. Again, since net farm income is a dollar amount, it is difficult to establish a standard for comparison across farm operations.
Rate of Return on Farm Assets (ROA)The rate of return on farm assets (ROA) measures the relative income generated by the assets of the farm business, and is often used as an overall index of profitability. The rate of return on farm assets is calculated as follows:
For agricultural businesses that are incorporated, or in which those involved in the operation take a salary withdrawal, wages would have been paid to the operator and family members employed by the business. For agricultural businesses that are not incorporated, a return to unpaid labor and management has not been subtracted as an expense. Because ROA measures the return to only the assets, a charge must be made for unpaid operator and family labor and management. Thus, a value for unpaid operator and family labor and management is subtracted. In estimating the dollar return to assets, the operator could subtract a return for his/her labor and management valued at what they could earn in alternative employment. This return is often referred to as the “opportunity return to labor and management,” and varies for different individuals depending on their opportunities for alternative employment. However, because this opportunity return does vary by individual, precise estimates of alternative earnings are difficult to obtain. A proxy for unpaid operator and family labor and management is the amount of withdrawals from the business or the amount listed as family living expense. If withdrawals are used, consistency across firms may be a problem. For example, family housing costs may be included in the withdrawal figure for some agricultural businesses, but they may be part of the farm mortgage interest expense for other agricultural businesses. Also, the withdrawal figure is sometimes higher or lower than the market opportunity cost of these resources, and it is often difficult to determine the market opportunity cost. If possible, however, one should compare the amount of family living expense with the opportunity cost of the labor and management resources to assess the realism of family living expenses as a proxy for unpaid operator and family labor and management. For this example, we used the family living expense as a proxy. This was found on the cash flow statement line 45. Finally, the ROA calculation is based on the average value of farm assets, rather than the beginning or ending asset values, because the return is generated for the entire year. Nonfarm assets should be excluded from the calculation of ROA for the agricultural business. Because the return is to farm assets, the denominator of the equation should only include farm assets.
The rate of return on farm assets will vary by farm type, but the higher the ROA value, the more profitable the farming operation. ROA is often compared to the average interest rate on borrowed capital or to the cost of new borrowing. If the ROA exceeds the cost of borrowed capital, then the borrowed capital is being used profitably in the business and increasing leverage will contribute to additional firm growth. If, however, the ROA is less than the cost of borrowed capital, borrowed funds are not being used profitably and increasing debt will reduce growth in equity. So, the level of profitability is an important key to successful use of debt financing as a strategy to increase the equity of the business.
where average total farm liabilities = [($272,910 + $519,248) + ($237,250 + $598,306)] / 2 = ($792,158 +$835,556) ÷ 2 = $1,627,714 ÷ 2 = $813,857
Rate of Return on Farm Equity (ROE)Another measure of farm profitability is the rate of return on farm equity (ROE). It is calculated as follows:
$ 31,546 Net farm income from operations
Operating Profit Margin RatioThe final profitability measure is the operating profit margin ratio, which measures the return to capital per dollar of gross farm revenue (or per dollar of value of farm production). The operating profit margin ratio is calculated as follows:
Measuring Financial EfficiencyThere are a number of ratios that measure efficiency, which is an important component of profitability. The ratios relate physical output to selected physical inputs, and help evaluate whether or not farm assets are being used efficiently to generate income. The measures most widely used and generally applicable to all types of agricultural businesses are the asset turnover ratio and four operating ratios: operating expense ratio, depreciation expense ratio, farm interest expense ratio, and net farm income from operations ratio. Asset Turnover RatioThe asset turnover ratio is calculated by dividing gross farm revenue by average total farm assets. The asset turnover ratio for the Madison’s, calculated using the market-value approach to valuing assets, is calculated as follows:
Important relationships exist between and among the rate-of-return on farm assets, the operating profit margin ratio, and the asset turnover ratio. Multiplying the asset turnover ratio by the operating profit margin ratio will equal the rate of return on farm assets. For the Madison’s operation, multiplying the asset turnover ratio of 0.119 by the operating margin ratio of -0.0077 then multiply by 100 results in the rate of return on farm assets of -0.0916 percent. The asset valuation approach used to calculate the asset turnover ratio must be the same as the approach used to calculate the rate of return on farm assets. In addition, non-business assets should be excluded from the denominator. Operational RatiosThe four operational ratios that reflect the composition of gross farm revenue (or value of farm production) are the operating expense ratio, the depreciation expense ratio, the farm interest expense ratio, and the net farm income from operations ratio. Operating Expense RatioThe operating expense ratio is calculated as follows: (Total operating expenses - Depreciation expense)
$248,652 ÷ $368,025 = .6756, or 67.5%
Depreciation Expense RatioThe depreciation expense ratio is calculated as follows: Depreciation expense ÷ Gross farm revenues
Farm Interest Expense RatioThe farm interest expense ratio is calculated as follows: Total farm interest expense ÷ Gross farm revenues
Net Farm Income from Operations RatioThe net farm income from operations ratio is calculated as follows: Net farm income from operations ÷ Gross farm revenues
For the Madison’s operation, the net farm income from operations ratio is as follows: If the four operational ratios discussed above are added together, the total should equal to 100 percent. For the Madison’s operation, the total of the four ratios is as follows:
Measures of Repayment CapacityRepayment capacity is the ability of the farm operation to cover its financial obligations as they come due. Two measures of repayment capacity which focus on the ability of the farm operation to repay term debt and capital lease obligations from farm and nonfarm income are the term debt and capital lease coverage ratio and the capital replacement and term debt repayment margin. Term Debt and Capital Lease Coverage RatioThe term debt and capital lease coverage ratio is calculated by dividing term debt and capital lease repayment capacity by term debt and capital lease repayment commitments. These components are reflected in the numerator and denominator, respectively, of the following equation:
÷ (Annual scheduled principal and interest payments on
+ $ 0 Interest on capital leases - $10,350 Total income and Social Security tax expense $ 33,630 Scheduled principal payments on term debt
Capital Replacement and Term DebtRepayment MarginAnother measure of repayment capacity is the capital replacement and term debt replacement margin. The margin is determined by calculating the capital replacement and term debt repayment capacity and then subtracting principal payments to be made on operating debt and the current portions of term debt and capital leases. The capital replacement and term debt replacement margin is calculated as follows: Net farm income from operations
This measure enables the operator and agricultural lender to evaluate the ability of the farm to generate funds necessary to repay debts that have maturity dates longer than one year and to replace capital leases. The measure also enables farmers to evaluate the ability to acquire additional capital or service additional term debt and to evaluate the risk margin for capital replacement and debt service.
$ 31,546 Net farm income
from operations
Summary and ConclusionsAnalyzing the level of key financial measures and their relationships can provide valuable insights to farm and ranch managers. Comparisons of measures from year to year signal whether the business financial performance is satisfactory and whether the financial position is improving or deteriorating. It is often very difficult to compare the absolute levels of financial measures for different farms due to fundamental differences in the size, capital requirements, and cash flow produced by the operations. For more information on the financial statements, see OSU Extension Fact Sheets AGEC-751, “Developing a Cash Flow Plan;” AGEC-752, “Developing a Balance Sheet;” and AGEC-753, “Developing an Income Statement.” 1 Based on an earlier version by Damona Doye. 2 This number is calculated by adding lines 51 and 53 used in the Madison Case farm on the Developing a Cash Flow Statement fact sheet. 3 This number is calculated by adding lines 52 and 54 used in the Madison Case farm on the Developing a Cash Flow Statement fact sheet. Was this information helpful?YESNO Which of the following ratios would be most useful in evaluating the profitability of a firm?Answer and Explanation: Return on asset ratio is a method used in profitability ratio to find a firm's profitability. It helps to find the net income obtained from the firm's total assets during a financial year.
Which of the following ratios provide a measure of business's profitability?The return on equity (ROE) measures a company's profitability concerning its stockholders' equity.
Which of the following is considered a profitability measure?Answer and Explanation: The return on asset (ROA) is one measure that is used by companies in order to know how profitable is the usage of their assets.
Which of the following ratios would be most useful in determining a company's?Answer and Explanation: Asset turnover ratio measures the efficiency of usage of the assets with respect to sales. Return on assets is typically an indicator of the profit of any company with reference to its assets.
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