Financial AnalysisAg ManagementChapter 3

Objectives

•Know the three kinds of financial analysis•Be able to calculate liquidity, solvency,

and equity•Understand income statements and the

ways to analyze them•Know how to calculate financial efficiency

ratios•Understand and calculate profitability

Financial Ratios

•Take information from the financial statements and use it to provide an evaluation of several financial aspects of the business

•Divided into measures for▫Liquidity▫Solvency▫Profitability▫Financial Efficiency

Liquidity

Liquidity• The ability of a business to generate enough cash

to pay bills without disrupting business operations• Determines the ability to meet short term debt and

other obligations from available cash or other current assets

• Measures include:▫Current Ratio▫Working Capital▫Debt Structure▫Asset Structure

• Fig 1 p. 3-2

Current Ratio

•Current assets/current liabilities•Measures the ability of the farm’s current

assets if sold to cover the short-term liabilities

•Fig 1 p. 3-2▫The Kendall farm has a current ratio of

2.15:1 which indicates that for every $1 of current liabilities the farm has $2.15 of current assets.

Working Capital

•Current assets – Current Liabilities•Reflects the actual dollars available after

current assets are sold and current liabilities are paid

•Fig 1 p. 3-2▫Working capital for the Kendall Farm is

estimated to be $202,972

Debt Structure• Current liabilities/ Total liabilities• Indication of the percent of total farm debt that is

due in one year• Fig 1 p. 2-3

▫For the Kendall Farm in year 2, 21.44% of the total farm debt is due within the next 12 months

• If debt is continued to be paid off without incurring new, the debt structure percentage should increase

• A decrease in debt structure from one year to the next indicates that new term debt was incurred during the year

Asset Structure• Current Assets/ Total Assets• An indication of the percentage of total assets

that will be used or sold in one year• Fig 1 p.3-2

▫For the Kendall Farm in year 2, the asset structure is 14.51%

• Not used frequently in business analysis• An asset structure less than debt structure can

be a symptom of farm liquidity problems▫Should not be used as a stand alone measure of

liquidity

Solvency

Solvency

•Measures the ability of all assets if sold at market value to cover all debts.

•A business is solvent if total assets exceed total liabilities

•Also examines the relationships between debt capital, funds borrowed and invested in the business and equity capital (the owner’s funds invested in the business)

Measures of Solvency

•Net capital ratio•Debt to asset ratio•Equity to asset ratio•Debt to equity ratio

Net Capital Ratio• Total farm assets/ Total farm liabilities• Shows the total dollar value of assets per dollar

of total debt• Influenced by the values placed on all farm assets• Over-valuing assets leads to inflated estimates of

net capital ratio• Any net capital ratio less than 1 would indicate

that total liabilities are greater than total assets and the farm business would be insolvent

• Higher net capital ratios are desirable• Fig 2 p. 3-3

Debt to Asset Ratio• Total Liabilities / Total Assets• Measures what percent of the total assets of

the farm business is owed to the creditors• Useful in measuring the amount of risk in

regard to debt against assets • Fig 2 p. 3-3

▫Debt to asset ratio for the Kendall farm decreased from year 1 to year 2 indicating that in year 2 the Kendall’s borrowed additional funds and total debt increased but that total assets values increased proportionally more

Equity to Asset Ratio• Total Farm Equity/Total Farm Assets• Measures the percent of total assets financed by

owner’s equity capital• An increase in the equity to asset ratio would

indicate an increasing owner’s claim against the farm assets

• Fig 2 p. 3-3▫The Kendall’s equity to asset ratio for year 2 is

68.5%, indicating they own 68.5% of the farm’s assets free and clear of any debt. The ratio also increased from year 1 to year 2 indicating an increase in the Kendall’s claim against the business

Debt to Equity Ratio

•Total Farm Liabilities/Total Farm Equity•Measures the relationship between debt

financing and equity financing by the farm•Often referred to as the leverage ratio

since it reflects the way debt and equity are combined to finance the farm business

•Ratio equal to 1 indicates equal amounts of debt and equity financing

•Ratio less than 1 indicates more equity financing than debt and vise versa

Profitability Measures

Profitability Measures

•Show how efficient a business is in generating a profit from the use of land, labor management and capital resources

•Include▫Net Farm Income from Operations▫Net Farm Income▫Return on Assets▫Return on Equity▫Cost of Debt▫Operating Profit Margin Ratio

Net Farm Income from Operations (NFIFO)•Total Revenue – Total Expenses, operating

and fixed•Considered to be the profit from the

typical operation of the farm or ranch business

•Also represents a return to unpaid operator and family labor, equity capital and management

•Fig 3 p. 3-4, 3-5

Net Farm Income (NFI)

•Net Farm Income From Operations + Any Gain or Loss on the sale of capital items such as land and machinery

•Gain or loss on capital sales is not considered a part of the normal operations of the farm is not included. Instead it is added after the calculation of NFIFO

Return on Assets (ROA)• Return to Assets

▫NFIFO + Interest (from income statement) – Opportunity Cost of Unpaid Operator and Family Labor

• Return on Assets▫Return to Assets/ Average total assets

• Interest is added to NFIFO to give returns to unpaid operator and family labor, total capital and management

• By adding the interest that was subtracted in the income statement the result is an NFIFO as if there was no debt to the farm

Return on Assets (ROA)-Opportunity Cost•For unpaid operator and family labor is

subtracted to reflect a payment for the contribution of operator and family labor that is not shown as an expense on the income statement

•Should be an estimate of the value of the operator and family labor in their next best alternatives

Return on Equity

•Return to Equity/Average Total Equity•Gives the rate of return on the owner’s

equity

Cost of Debt (COD)

•Total Interest (from the income statement)/Average Total Liabilities (from Net worth statement)

•Should not be interpreted as an interest rate on a particular loan

•Simply gives interest as a percent of total farm debt

•Useful in estimating if debt capital is beneficial to the business

Cost of Debt & ROA & ROE*

•ROA > COD then ROE will be higher than ROA

•ROA< COD then ROE will be lower than ROA

•If the COD is less than the ROA causing ROE to be greater than ROA then the debt capital is beneficial to the farm business

Operating Profit Margin Ratio (OPMR)

•Operating Profit Margin▫NFIFI + Interest – the opportunity cost of

unpaid operator and family labor▫Same calculation as the return to assets

•Operating Profit Margin Ratio▫Operating Profit Margin/ Total Revenue

(from income statement)

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)

• Net Farm Income from Operations + Interest Expenses, Depreciation expense and amortization expense

• Amortization expense refers to the proration of intangible assets ▫Similar to depreciation but applies to assets such as

copyrights and patents• A measure of profitability that examines the

repayment capacity of the business• Can be compared to upcoming principal and

interest payments to reflect the adequacy to cover scheduled debt payments on term debt

Financial Efficiency

Financial Efficiency

•Measures how effective the business is in generating revenue from the production and management decisions

•Measures▫Asset Turnover Ratio▫Operating Expense Ratio▫Depreciation Expense Ratio▫Interest Expense Ratio▫Net Farm Income from Operations Ratio

Asset Turnover Ratio (ATR)

•Gross Revenue (from income ratio)/ Average Total Assets (from the net worth statement)

•Measures the operational efficiency by indicating the level of revenue generated per dollar of assets owned by the business

Operating Expense Ratio (OER)

•Total Operating Expenses – Depreciation/ Total Revenue

•Reflects the percent of total revenue devoted to operating expenses except depreciation

•Depreciation is treated as separate efficiency ratio

Depreciation Expense Ratio

•Total Depreciation Expense/Total Revenue•Shows the percent of total revenue

devoted to depreciation expense

Interest Expense Ratio

•Total Interest Expense / Total Revenue•Percent of total revenue devoted to

interest

Net Income from Operations Ratio•Net Farm Income from Operations/Total

Revenue•Shows the percent of total revenue that

remains for net income after all operating expenses and interest have been subtracted

Efficiency Ratio Wrap-Up

•Operating Expense Ratio, Depreciation Expense Ratio, Interest Expense Ratio and Net Farm Income Operations Ratio will always add up to 100%

•Each represents a portion of total expenses and net farm income is the percent of revenue remaining after all expenses

Summary*• Financial ratios are a useful tool to measure the

financial health of the farm or ranch business• Ratios

▫provide trend analysis and comparative analysis▫Assist in indentifying possible strengths and

weaknesses in the financial condition of the business

▫Should be interpreted cautiously due to difficulties in the consistency of accounting data

• Ratio analysis is another tool in management of the business and can provide symptoms of financial problems