What are two or three of the most important ratios to monitor on your financial statements? This was a challenging question I received at a recent agriculture lender and producer conference. Thirty years ago, I was an original facilitator of the Farm Financial Standards Task Force responsible for recommending consistent financial ratios to evaluate agriculture operations. Today’s Farm Financial Standards Council recommends 21 ratios, so narrowing the list to two or three is difficult.
One of the areas that needs to be intensely analyzed is the top half of the balance sheet. Working capital is a measure of liquidity calculated using current assets minus current liabilities. Rather than using the current ratio or working capital to revenue, I prefer the working capital to expenses ratio. If revenues decline and working capital remains the same, the working capital to revenue ratio will improve and give a false positive signal. Working capital to expenses indicates what percent of the expenses can be covered by the owner versus the lender.
Carefully analyze the balance sheet this winter, particularly with the buildup of unmarketed grain inventory. Stagnant inventory can yield a higher working capital to expense ratio and give a false sense of the adequacy of working capital available. While the working capital to expenses ratio may look strong, how quickly can the current assets be converted to cash? What are the operation’s expenses and debt service needs and how does this compare to the value of the inventory assets? What are the accounts receivable and are they collectible? When will the accounts payable and operating expenses be due? If you utilize prepaid expenses and they are included as current assets, how long will it be before these expenses will be used to generate revenue? Often, it will be anywhere from one year to 18 months of lag time.
One of my favorite ratios is calculated by dividing operating expenses, excluding depreciation and interest expenses, into total revenue. The ratio quantifies financial efficiency of the business. If this ratio is monitored monthly or quarterly, one can make adjustments in revenue and expenses as the year progresses.
Finally, I recommend monitoring the term debt and lease coverage ratio monthly or quarterly to evaluate repayment ability. This ratio is the Farm Financial Standards Council’s metric that lenders utilize to gauge a borrower’s ability to service debt. The term debt and lease coverage ratio is calculated by dividing the total repayment capacity of the business by the annual debt service payments. The goal is to make sure the ratio exceeds 100 percent, but preferably above 125 percent.
This is not meant to discount the utility of any other financial ratios, but these are a few quick, user friendly ratios to focus on when evaluating the health of your agriculture operation.
Source: Dr. David Kohl, which is solely responsible for the information provided and is wholly owned by the source. Informa Business Media and all its subsidiaries are not responsible for any of the content contained in this information asset.
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