Why should a producer analyze the farm operation? A financial analysis of the farm operation is done to determine the financial position and performance of the business. The financial analysis of an agricultural business must focus on both its present position (called its financial position), the results of its operations, and its past financial decisions (called financial performance). The farm’s financial position refers to the total resources controlled by the farm business and the total claims against those resources at a single point in time. Measures of the financial position provide an indication of the capacity of the farm business to withstand risks. It also provides a benchmark to compare with the results of future farm business decisions. The financial performance refers to the results of the farm business’s production and financial decisions over one or more periods of time. Measures of financial performance include the impact of external forces that are beyond anyone’s control (i.e., drought, state health regulations that restrict the sale of goat milk or foreign imports of frozen goat meat) and the results of the farm’s operating and financial decisions made in the ordinary course of business.

How does a producer analyze his agricultural operation? There are several steps that can help farmers to analyze the farming operation. These steps should be completed in the order that they are listed.

1. Determine the objectives of the analysis . Is the analysis being conducted to determine the tax liability? Is the analysis being done to apply for credit? Is the analysis being done to determine the health/profitability of the operation?
2. Describe the business organization and its goals . Is the operation expected to make a profit? Are there measurable goals with regard to profit and growth? Who is in charge of analyzing the business?
3. Prepare financial statements. Be sure to exercise be consistent between years so the comparisons will be valid. Make sure that the data is accurate and complete. Be sure to include accrual adjustments.
4. Calculate the financial ratios and prepare historical and projected financial summaries. Again, check for consistency and accuracy.
5. Compare your farm’s results to similar operations if benchmarks are available .
6. Summarize the analysis to help when reviewing at a later date . Strengths and weakness should be expressed in a clear, concise manner in a way that the reader can use and see any limitations of the analysis.

Where to start?

1. The Income Statement (Profit and Loss Statement) summarizes income and expenses for a certain time period, usually a calendar year. The last line of the income statement its “Net Income” or “bottom line” tells how much profit or loss the farm exp erienced. If that number is positive, the farming operation made money, if it’s negative, it lost money.
2. Then look at the beginning and ending balance sheets. The balance sheet summarizes the assets and liabilities of the operation at a particular poi nt in time. Assets are tangible property, products, or inventories, etc. that the operation either owns or is currently buying on credit. Liabilities are what the operation owes its creditors for the purchase of assets or any other financial obligations. If the dollar amount of assets exceeds the dollar amount of liabilities, the owner has equity. Equity is often referred to as Owner Equity and is the dollar amount of the operation that the owner actually owns. A word of caution…Changes in equity from year to year can be due to the way assets are valued. Consistency is the key.
3. The next step is to calculate certain financial measures and ratios. They are generally divided into five categories:
   1. Liquidity – If the farm’s current assets are sold, will they cover its current debts? Will there be funds left over?
   2. Solvency – Can the farm repay all of its debts if all of its assets are sold?
   3. Profitability – This measures the performance of the farming operation over a year that result from the decisions that are made regarding the use of land, labor, capital and other management resources;
   4. Financial efficiency ratios compare physical output to selected physical inputs and help to evaluate whether or not the farm assets are being used efficiently to produce income; and
   5. Repayment capacity.

Financial Measures and Ratios

1. The two balance sheet measures most often used to evaluate Liquidity are the current ratio and working capital.
   1. The current ratio is the relationship between current farm assets and current farm liabilities. It is calculated as:
      Current Ratio=Total current assets ÷ Total current farm liabilities

      The ratio indicates the extent to which current farm assets, if liquidated, would cover current farm liabilities. The higher the ratio, the greater the liquidity. If the ratio is greater than 1.0, the operation is considered liquid. If the ratio is less than 1.0, the operation has some degree of cash flow risk. Generally, lenders and financial analysts like to see a current ratio of 1.5 to 2.0. One consideration when calculating the current ratio is deferred taxes. Because the ratio determines the impact of selling all current assets, the tax consequence should be considered. It is therefore a more conservative approach to include deferred taxes as a current liability when calculating the ratio.

   2. Working capital is a measure of the amount of funds available after the sale of all current assets and the payment of all current liabilities at a single point in time. It is calculated as:
      Working Capital = Current farm assets – Current farm liabilities

      Because working capital is expressed as a dollar amount, it is difficult to make comparisons between operations. Generally, working capital should be positive, but the amount needed depends on the type and size of the operation, the time of the year, and the related seasonality of the production cycle.

2. The measures for Solvency. Solvency indicates the farm business’s ability to repay all of its debts if all the assets were sold. If the value of the total farm assets exceeds the value of the total farm liabilities, the farm is said to be solvent. If the sale of all the farm assets would not be enough cash to pay off all liabilities, the farm is insolvent. The difference between the value of total farm assets and total farm liabilities, referred to as net worth or owner’s equity, is the most often used measure of solvency. The most realistic approach to calculating solvency (owner’s equity) is to use the market-based value of the assets, including the consideration of deferred taxes. There are three commonly used ratios to measure financial solvency are the equity-to-asset ratio, the debt-to-asset ratio, and the debt-to-equity ratio. All three of these ratios are related and neither is necessarily preferred.
   1. The equity-to-asset ratio measures the proportion of total farm assets owned or financed by the owner’s equity capital. It is calculated as:
      Equity-to-Asset Ratio = Total farm equity ÷ Total farm assets

      The higher the equity-to-asset ratio, the more capital is supplied by the farm owner and the less is supplied by creditors. There is no exact standard for the equity-to-asset ratio that should be applied to every farm business. However, as the percent equity increases above 0.50, the owner is supplying a greater percent of the total assets in the business than the creditors. This ratio should increase over time if the owner retains farm profits and reduces debt obligations.

   2. The debt-to-asset ratio measures the proportion of total farm assets owed to creditors. It is calculated as:
      Debt-to-Asset Ratio = Total farm liabilities ÷ Total farm assets

      The higher the ratio, the greater the risk to the farm business and those who are providing loan funds. The operator has less flexibility to respond to adverse natural or market conditions. As with the equity-to-asset ratio, there is no exact standard for every farm business. However, a debt-to-asset ratio greater than 0.50, indicates that the owners contribute less than 50 percent of the value of the farm’s assets. In with this situation, creditors are often cautious about making loans.

   3. The debt-to-equity ratio measures the proportion of funds invested by the creditors versus the farm owners. It is calculated as follows:
      Debt-to-Equity Ratio = Total farm liabilities ÷ Total farm equity

      The higher the debt-to-equity ratio, the more total capital is supplied by the creditors and less by the farm owner. This ratio is also referred to as the leverage ratio. Leveraging refers to increasing the use of debt relative to equity as a means of financing the business. 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’s risk and the longer the loan’s term, the lower the lender wants the debt-to-equity ratio to be.

3. The measures for Profitability. Profitability measures the financial performance of the operation over a period of time, usually one year, that result from the decisions made regarding the use of land, labor, capital and other management resources. The five commonly used measures to assess profitability are net farm income, net farm income from operations, rate of return on assets, rate of return on equity, and the operating profit margin.
   1. The rate of return on 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 ROA is calculated as follows:
      ROA =
      (Net farm income from operations) + (Farm interest expense) – (Value of unpaid operator and family labor and management)
      —————————————————————————————————
      Average total farm assets

      Once the income statement has been developed, the net farm income from operations and the farm’s interest expenses can be taken directly from the income statement. The value of unpaid operator and family labor and management must be estimated. Withdrawals from the business for family living expenses can be used to estimate unpaid operator and family labor and management. The average total farm assets can be calculated by adding total assets from the beginning balance sheet plus total assets from the ending balance sheet and dividing by 2. This ratio is often used as an overall index of profitability. It is best to use the cost basis approach when evaluating your individual farm business over time because market based values fluctuate over time. But, when comparing your farm to other farms, it is best to use the market value approach to value the farm assets, because cost basis values can cause extreme differences between farm businesses.

      The rate of return on assets will vary among different types of agricultural operations, but the higher the ROA, the more profitable the operation. While the ROA is most often compared across years within an operation, the ROA for any particular year can also be compared to the average interest rate the operation is currently paying or to the cost of new borrowing. If the ROA exceeds the interest rate of the new proposed borrowing, then borrowing more can be used to profitably grow the business (equity). However, if the ROA is less than the average interest rate that the operation is currently paying, then borrowed funds are not being used profitably, and adding new debt will reduce the growth of equity. Therefore, the level of profitability is an important key to the successful use of debt financing as a strategy to increase the equity of the operation. It should be noted that the ROA in most agricultural operations might seem low when compared to non-agricultural investments such as stocks and bonds. This is important and re-enforces the notion that people invest in agricultural operations for reasons other than profit and equity growth.

   2. The rate of return on equity (ROE) is another measure used in determining financial performance or profitability. The ROE is calculated as follows:
      ROA =
      (Net farm income from operations) – (Value of unpaid operator and family labor and management)
      ————————————————————————————————
      Average total farm equity

      As with the previous calculation, the net farm income from operations and farm interest expense can be taken directly from the income statement, while the value of unpaid operator and family labor and management must be estimated. The average total farm equity can be calculated by adding the total farm equity from the beginning balance sheet plus the total farm equity from the ending balance sheet and dividing by 2. In general, the higher the ROE, the more profitable the farm business.

4. Measures of farm Efficiency. There 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 the farm assets are being used efficiently to generate income. The efficiency measures most widely used in agricultural businesses are the asset turnover ratio and the four operating ratios: the operating expense ratio, the depreciation expense ratio, the farm interest expense ratio, and the net farm income from operations ratio.
   1. The Asset Turnover Ratio measures how efficiently farm assets are being used to generate gross revenue. Consideration should be given to the way in which the assets are valued and the same approach used to calculate the ROA should be used to calculate the asset turnover ratio. It is calculated as follows:
      Asset Turnover Ratio =
      Gross farm revenue
      ————————————
      Average total farm assets

      The higher the ratio, the more efficiently assets are being used to generate revenue. The agricultural industry as a whole tends to have both a slow rate of asset turnover and a relatively low operating profit margin.

   2. The Operating Expense Ratio reflects the extent to which gross farm revenues are expended on farm operating inputs, excluding depreciation and interest. The higher the value of the ratio, the larger the proportion of gross farm revenues is needed to offset all of the operating expenses. Ratios in the 40 to 60 percent range indicate relative efficiency, with efficiency declining as the ratio rises. The operating expense ratio is also used as one of four operational ratios.
      Operating Expense Ratio =
      (Total operating expenses) – (Depreciation expenses)
      ————————————————————————
      Gross farm revenues

   3. The Depreciation Expense Ratio measures the proportion of gross farm revenues that are represented by the depreciation expense (a non-cash expense). A relatively low depreciation expense ratio could indicate little difficulty in making planned and timely replacements of capital assets, or it may indicate that capital assets (usually farm machinery) are relatively old. It should be noted that IRS depreciation rules could distort this ratio and you should use management depreciation. This is also used as one of four operational ratios.
      Depreciation Expense Ratio =
      Depreciation expense
      ——————————
      Gross farm revenues

   4. The Interest Expense Ratio measures the proportion of gross farm revenues that are required to cover the farm’s interest expenses. Large interest expense ratios are characteristic of highly leveraged operations. As a general rule, the interest expense ratio should be less than 0.15. Interest expense ratios over 0.15 indicate that farm’s interest expenses are a large proportion of its gross revenues and that the farm is likely suffering “financial stress.” The farm interest expense ratio has important implications for the profitable use of debt financing and financial risk. As indicated in earlier discussions of profitability, if the rate of return on farm assets (ROA) exceeds the cost of debt financing, increasing debt can increase the growth in farm equity. The interest expense ratio is also used as one of four operational ratios.
      Interest Expense Ratio =
      Total farm interest expense
      ————————————
      Gross farm revenues

   5. The Net Farm Income from Operations Ratio measures the net farm income as a proportion of its gross revenues. Thus, it reflects the proportions of gross farm revenues that remain after the farm operating expenses have been paid. It is calculated on a before-tax basis. The net farm income from operations ratio is also used as one of four operational ratios.
      Net Farm Income from Operations Ratio =
      Net farm income from operations
      ———————————————
      Gross farm revenues
5. The four operational ratios discussed above (b. through e.), when added together, should equal to 1.0 or 100 percent. The producer should always keep in mind that all of these ratios can vary widely between different operations and from year to year within an operation due to different types of farms and different marketing and production systems. Therefore, it is important that farmers compare projected values for the coming year to the most recent averages for their own operation.

Review Questions

1. Two measures used to assess profitability are the rate of return on assets and the rate of return on equity. (True or False) True.

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