As a farmer, regular check-ins with your finances will help you optimize your operation. Much like checking the fluids, hoses and belts in your field equipment, a ratio analysis offers a quick checkup on the financial health of your ag enterprise.
There are several methods to conduct a ratio analysis, with various formulas that measure liquidity, operational efficiency and the profitability of your farming enterprise.
To get the full picture of your farm’s financial position, it’s important to extract data from multiple ratios. Doing so will help you adequately assess your strengths and weaknesses, so you can build on what’s working and find proactive solutions for the problem areas.
Planning for the future? Maybe you’re looking at a new commodity, expanding your enterprise or thinking ahead to succession planning. Throughout the process you’ll want to capture the vital signs of your farm’s financial performance. Ratios can let you know if you’re on track to reaching your goals and what you need to focus on to achieve them.
As you’re reviewing financial statements, tracking your financial ratios in a spreadsheet helps you gauge your progress and set goals. As trends emerge over the months and years, you’ll be well-equipped to quickly identify issues and build on your strengths.
Lenders often rely on financial ratios to assess the borrower’s capacity to repay a loan. Running your ratios in advance of your meeting with an ag lender can help you arrive aware and prepared. When you can confidently discuss your finances and present solid plans to strengthen your enterprise, it enhances your credibility with the lender and increases the likelihood of securing the loan.
Having a cash cushion is a critical measure of your farm's financial health because it enables you to service your debts and cover unexpected costs. The current ratio is an indicator of whether your current assets can cover short-term debts in the coming year.
What are current assets? Current assets include checking accounts, savings accounts, certificates of deposit (CDs), as well as forecasted revenues from the normal course of doing business. In other words, you would consider the commodities you would typically sell. Revenues from one-time sales, such as a piece of equipment or a parcel of land, would not be included.
The formula: Current Ratio = Current Assets / Current Liabilities.
What to aim for: A farm with a current ratio of 2.0 indicates that for each dollar of short-term debt, there are $2 worth of assets to cover the costs. At this level, the operation is in a position of financial strength.
However, when the current ratio is less than 1.0, that signals you may not have enough cash coming in to cover your short-term liabilities. Also, ratios higher than 2.0 indicate an inefficient use of assets — perhaps it's time to consider increasing your investments.
The total asset turnover ratio helps you gauge the efficiency of your operation, how the assets generate farm revenue. It measures the relationship between your revenues and the value of your assets.
Tracking this ratio allows you to measure your progress and the effectiveness of any changes made to your operation. An increase in the ratio indicates improved efficiency, while a decrease suggests that your assets are not being optimized to generate sales.
Formula: Asset Turnover = Total Sales / Average Assets.
To calculate the average assets, add the asset balance at the beginning of the year to the asset balance at the end of the year and then divide by 2.
What to aim for: For a farming operation, it is advisable to aim for an asset turnover ratio of 40% or higher. This indicates a more efficient use of assets in generating farm revenue.
This formula reveals the extent to which debt is being used to finance your farming operation, comparing the level of overall debt to your equity.
Lenders use this ratio to assess whether a new round of financing would drive growth or potentially put your operation in financial jeopardy. As a critical ratio for lenders, it is essential for producers to monitor it on a quarterly basis.
Formula: Farm-Debt-to-Equity Ratio = Total Debt / Total Equity.
What to aim for: For the farm debt to equity ratio, you'll want it to be no more than 1. Striking the right balance is crucial for maintaining financial health and maximizing growth potential. If your debt-to-equity ratio is higher than the industry average, it can indicate higher risk for lenders. On the other hand, a ratio well below the industry norm may reveal that your operation isn't utilizing financing to expand effectively.
This formula is another tool that focuses on loan repayment. In this case, lenders use it to determine if you have sufficient cash flow to service your debts and make timely payments. You can also use this formula to identify trends and forecast your ability to repay loans effectively.
Formula: Term Debt Coverage Ratio = Net Operating Income / Debt Service.
Formula: Term Debt Coverage Ratio = EBITDA* / Debt Service
[*Earnings Before Interest, Taxes, Depreciation, and Amortization]
What to aim for: A ratio that's less than 1 signals inadequate cash flow levels to cover debts, indicating a potential challenge to meeting your obligations. On the other hand, aiming for a ratio of 2.0 indicates a financially strong operation with substantial cushion to handle unexpected expenses and comfortably service debt obligations.
Ready to take your ag enterprise to the next level? Turn to the ag banking experts at Minnwest Bank. We’ll listen to your goals and come up with workable lending and leasing solutions tailored specifically to your operation. With our connections to agriculture and your community, we’re committed to helping you succeed. Contact an ag banker today.