Business side: Financial ratios

CONVERSATIONS WITH BUSINESS EXPERTS

Bruce Robinson, CPA, CA, Partner, RLB LLP

(R.H.) HOW DO YOU RECOMMEND FINANCIAL PERFORMANCE BE ANALYZED?
(B.R.) The process of completing year-end reporting should not stop once the annual financial statements are finalized with an accountant. Good statements — including a balance sheet, income statement, cash flow statement, and notes — provide growers with the opportunity to calculate financial ratios to measure performance. Ratio analysis measures strengths and weaknesses and can help to identify opportunities.

WHAT KEY TERMS SHOULD I BE FAMILIAR WITH?
Working capital is current assets less current liabilities. This ratio should be positive. If growers look at what expenses are coming up in the next three to six months, it is important to ask how much working capital there is. When figuring out cash expenses for the next year, managers should know how much working capital they have to work with. If their answer is less than 30 days’ worth, a new strategy is needed.

Current ratio (liquidity ratio) is current assets divided by current liabilities. This ratio reveals if a business can meet their current obligations as they come due. A current ratio of 1:1 would show that current assets could retire the current liabilities with no value of assets left over. It is an important calculation from a financing perspective as banks would like to see 2:1 or stronger in a perfect world. The benchmark or average in grain farming is 1.7:1.

Quick ratio is cash plus accounts receivable, divided by current liabilities. This ratio is an indicator of the farm’s short-term liquidity as it measures the ability to meet short-term obligations with the most liquid assets. 1:1, meaning $1.00 of liquid asset to cover $1.00 of obligation, is a good score for growers to aim for.

Debt service coverage ratio is earnings before interest, tax, depreciation, and amortization (EBITDA), divided by annual principal and interest paid. Knowing the farm’s EBITDA means knowing how much money is available to make debt payments which can be helpful when making decisions such as buying new equipment and incurring the related debt. This ratio can also be used to understand future cash flows — how much EBITDA does the business need to generate before it is able to service the purchase of farmland? The average is 1.5:1, meaning from every $1.50 of money available to service debt, $1.00 is used to make payments.

Gross profit margin is gross margin (sales less cost of goods sold) divided by total revenue. This ratio shows the percentage of each dollar of a farm’s revenue that is available after direct costs of production. I recommend that growers review this section of the income statement in detail to review what is listed as costs of goods sold; noting that gross profit is what is left to pay all other expenses.

Debt to equity (leverage ratio) is total liabilities divided by total equity. This ratio shows the balance between money or assets owed versus owned. Banks consider this a very important calculation so growers looking for financing should be monitoring their leverage. Banks prefer a lower ratio to decrease financial risk.

Return on equity is net income divided by total equity. To me, this is a key driver of how an operation is doing. It shows how much profit is being returned on the shareholder’s equity each year. The higher, the better. This ratio is an important factor of the farm’s success today and in the future.

Return on assets is net income divided by total assets. Farmers invest in assets and this ratio asks the question: how is the business doing in return? It indicates how many cents of profit each dollar of asset is producing each year. The higher, the better.

WHAT TIPS CAN YOU OFFER TO IMPROVE RATIO ANALYSIS?
It’s important to regularly analyze how the farm is performing and some people have their own way of looking at this — it could be yield per acre, cost per acre, the results of marketing opportunities, and so on. Most of the important drivers needed to measure performance are captured in financial statements, but some growers may use other data systems to keep records as well. Ideally all information that is used to analyze performance should be entered into the system where bookkeeping records are stored, making comparable data easy to pull.

Growers should be comparing their own ratios from year to year but to make the analysis mean more, I also recommend that benchmarks are used. Accountants can refer to appropriate government benchmark data sources or subscription-based reports, depending on the type of operation.

I encourage growers to review key ratios with their accountant because we will be able to indicate whether their calculations are higher or lower than average and where the strengths and weaknesses are. Operators often know their strengths but sometimes bookkeeping isn’t one of them. When this is the case, I really recommend either taking the time to learn more or hiring someone to manage the books. Many producers know their operating cycles well but as the farm expands – acquires new assets or adds employees, for example – I’ve seen managers start to lose sight. As the operation grows, the investment in record keeping systems and performance management procedures needs to grow as well. •