Financial Management and Ratio Analysis for Cooperative ...


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Financial Management and Ratio Analysis for Cooperative ...

  1. 1. United States Department of Agriculture Financial Management Rural Business– Cooperative Service and Ratio Analysis for RBS Research Report 175 Cooperative Enterprises
  2. 2. Abstract This study discusses differences in financial management and goals between the investor-oriented firms and cooperatives. It briefly reviews what bankers look for when appraising potential borrowers. A summary of standard financial ratios used to analyze a variety of business structures is included, along with other modified ratios to address deficiencies evident in standard ratios. Key words: Cooperatives, fin n i l r t o l q i i y, l v r g , a t v t p o a i i y. a c a a i , i u d t e e a e c i i y, r fit b l t Financial Management and Ratio Analysis For Cooperative Enterprises David S. Chesnick Rural Business-Cooperative Service U.S. Department of Agriculture Research Report 175 January 2000 Price: Domestic — $5.00 Foreign — $5.50
  3. 3. Preface Several unique financial characteristics differentiate a cooperative from an investor-ori- ented firm (IOF). When evaluating the cooperative’s performance, comparing a coop- e a i e financial position with an IOF can be misleading for those unfamiliar with r t v ’s these characteristics. This report was written to help boards and managers assess the financial performance of their cooperatives and to familiarize potential creditors with the unique financial characteristics and performance of cooperatives. This study discusses the differences in financial management and goals of coopera- tives versus IOFs. It starts by discussing the contents of the various cooperative finan- cial statements and follows with a view of common sizing statements for analysis. Next, it reviews the usefulness of standard financial ratios applied to the cooperative framework. A brief review shows what lenders look for when analyzing potential bor- rowers. Finally,financial ratios are developed to build on these standards with an eye toward a comprehensive understanding of a cooperative s performance. Ratios will be related to data during the last 18 years from the largest agricultural cooperatives. i
  4. 4. Contents Preface .............................................................i Introduction ..........................................................1 Financial Statements ...................................................2 Financial Statement Analysis .............................................4 Common-size Statements ..........................................6 Analysis of Cash Flow .............................................8 Ratio Analysis ....................................................9 Standard Financial Ratios .....................................11 Interdependence of Ratios .....................................11 Trends over Time ............................................12 Ratios for Cooperatives ................................................12 Data ..........................................................13 Conversion Period of Inventories ....................................13 Payout Ratio ....................................................14 Capitalization Growth Rate .........................................14 Profit Index .....................................................15 Local Return on Local Assets .......................................15 Earnings Va i b l t ...............................................16 raiiy Income Quality Ratio .............................................16 Cash Interest Coverage Ratio ......................................17 Conclusion ..........................................................17 Bibliography .........................................................18 i
  5. 5. Contents
  6. 6. Financial Management and Ratio Analysis for Cooperative Enterprises David S. Chesnick RBS Agricultural Economist Why then would a producer invest in a coopera- Introduction tive? Why would someone be willing to give up access to these funds without the traditional investment An analyst must have a clear understanding of incentives? The unique nature of the cooperative the firm’s objectives to effectively measure its business owner/user relationship weakens this theory of proi ft performance and management. In most financial text- maximization. Benefits of ownership are not gained books, the objective of a company is maximizing the f rom the appreciation of the cooperative stock value, value of the owner’ i t rest in the firm. For the s ne btf u rom assured access to competitively priced sup- investor-oriented firm (IOF), the firm’s value depends plies, assured product market through the cooperative, on earnings used to reward investors and to reinvest in or simply access to goods and services not available productive assets that will generate future earnings. elsewhere . The interdependence of a firm’s value and its To further illustrate the diffrent functions e earnings has led to the theory of profit maximization. between the cooperative and IOF, consider this exam- The firm seeks optimum current and future earnings. ple of a simplified income statement: This ensures that the long-run return for investors is maximized through increased returns and the firm’s Sls ae appreciating stock value. Less Cost of goods sold On the other hand, cooperatives have goals other — — — — — — — — — — — than generating dire t p c rofits for their members. Thus, Equals Gross Margin in the cooperative environment, the interdependence Less Operating expenses giving rise to the theory of profit maximization gener- — — — — — — — — — — — ally will not hold true. In a cooperative, owners are t e h Equals Pro i s ft primary users. Cooperatives have objectives other than generating dire t p c rofits for its owners. These unique Assuming a cooperative and an IOF have identi- objectives may cause operational decisions made by cal operating expenses, profit for each is achieved by cooperative managers and directors to sometimes dif- maximizing the gross margin. If one assumes a com- frf e rom those made by management of IOFs. petitive external market, then the cooperative and the Investment in a cooperative is primarily based on IOF must take the price each receives as given, and, investors use of it. Appreciation in the value of mem- there o , c n i c f re a n rease gross margins only by reducing bers equity is not common. Additionally, l g l require- ea cost of goods sold (COGS). The IOF’s function is to ments often limit dividends paid on cooperative stock. return more to the investors, thereby trying to lower As a result, the traditional theory of the firm does not the COGS and increase the pro i s ft. fully hold in the cooperative environment. Profit maxi- In a marketing cooperative, the COGS largely mization translates into neither greater dividend represents payments to the member/owners for prod- sreams nor appreciated value of the member’s coop- t ucts marketed through the cooperative. There o , t e f re h erative investment. cooperative seeks to return the highest amount to the member,trough higher COGS and lower “pro i s ” h ft. 1
  7. 7. In a farm supply cooperative, sales larg l repre- ey ally stated at historical cost (what the cooperative paid sent purchases by the member/owner for product for it). However, some accounting standards prescribe received from the cooperative. Again, assuming com- using current market values for specific assets. petitive external markets, both the cooperative and the The stated liabilities indicate the amount owed IOF must take the price at which it purchases the prod- and are stated at cost. Members’ equity is the diffr- e u t f r resale as given (i.e., COGS is given). There o , c o f re ence between assets and liabilities. The balance sheet gross margins can be increased only by raising the o Farmer Cooperative is shown in t b e 1. Notice that f al sales price placed on farm supply products. While this cooperative equity is divided into allocated and unal- is sound business for an IOF, the cooperative seeks to located portions. Allocated equity is owned by specific limit these prices for its members, thereby reducing members. Unallocated equity is not earmarked for spe- pro i s ft. cific members and is used as a general reserve. Another concern facing cooperatives is the tre t- a The operating statement ( a l 2 r t b e ) eveals a coop- ment of equity. Under most circumstances, equity is erative’s performance during a particular period of risk capital and usually considered permanent in IOFs. time, such as the fiscal year ending Dec. 31, 2001. It On the other hand, Cobia and Brewer claim that much reports revenues from sales, services, and patronage of cooperative equity is temporary because coopera- refunds received from other cooperatives. It also tives have an implied obligation to redeem it. includes various costs, including the cost of goods However, the equity is not temporary. Rather,i i ts sold, general and administrative expenses, intere t s dynamic. Boards generally try to maintain an equity expenses, and taxes. Some marketing cooperatives base, but those who use the cooperative and own that report the results of their commodity pools in the oper- equity may change from year to year depending on the ating statement. ueo i. s f t The Statement of Cash Flows (SCF) indicates cash From an analytical point of view, the most signifi- receipts and cash disbursements during the accounting cant information in the equity section of the balance year. The SCF summarizes the operating, investing, s e t relates to the composition of the capital accounts he and financing activities of a business enterprise during and to restrictions. The analyst must know how to an accounting period and completes the disclosure o f reconstruct and to explain changes in the capital changes in financial position that are ’ readily appar- nt accounts, especially with cooperatives. ent in comparative balance sheets and income state- An analysis of restrictions imposed on the distri- ments (t b e 3) al . bution of equity usually sheds light on the coopera- The SCF complements the financial description of tv’ f i e s reedom of action in such areas as patronage dis- a business when used in conjunction with the operat- tributions and levels of working capital. Such ing statement and balance sheet. Looking at annual restrictions also note the cooperative’s bargaining “ rends” of cash flows over several years enhances the t srength and standing in the credit markets. Moreover, t analysis. The SCF presents “pure cash flow” informa- a c re u reading of the covenants will enable the ana- a fl tion that sometimes is diff c l t g e n f i u t o l a rom the other lyst to assess the potential for default. statements. Decisions that might not affect the long-run abili- ty of the firm to generate a positive net income may Financial Statements affect the cash flow information disclosed for a partic- ular period. The net cash flow from operations, how- A brief review of cooperative financial statements ever, shouldn’t be viewed as a substitute for net is warranted before starting a discussion of financial income. Both the cash and accrual descriptions of analysis. Financial statements provide certain basic events are important, and the inclusion of an SCF information that focuses on the entity as a whole and ensures that both will be available for the assessment meets the common needs of external users. Three main of the future cash flow and income potential of the financial statements arerequire fd rom businesses—a cooperative. statement of financial position (balance sheet), a state- One additional financial statement is frequently ment of activities (operating statement), and a state- available in the annual reports issued by cooperatives. ment of cash flows. The Statement of Changes in Members Equity (table 4) The balance sheet states the cooperative’s assets, describes how various equity accounts are a ffected liabilities, and members equity as of a particular date, for example, as of Dec. 31, 2001. Asset values are usu- 2
  8. 8. Table 1—Farmer Cooperative’s balance sheet for years ended Dec. 31, 2000 and 2001 Assets 2001 2000 Dollars Current assets Cash and equivalents 113 7 Accounts receivable 12,092 13,511 Inventories 21,825 20,805 Other current assets 333 ______ 274 ______ Total Current Assets 34,364 34,596 Investments Bank for Cooperatives 3,679 3,225 Other cooperatives 505 443 Other businesses 0 0 Other investments ______0 ______0 Total Investments 4,184 3,668 Net plant, property and equipment 22,424 19,086 Other assets 312 ______ 301 ______ Total Assets 61,283 57,652 Liabilities and Members Equity Cretlaiiis urn iblte Current portion long-term debt 1,246 1,783 Seasonal notes and loans ______8 9,188 ______ Total Short-term Liabilities 1,254 10,971 Trade accounts payable 20,359 13,234 Cash payments to members 2,477 738 Patron and pool liabilities 0 0 Ohrcretlaiiis te urn iblte 2,001 ______ 1,054 ______ Total Current Liabilities 26,091 25,998 Long-term Debt 10,677 9,927 Other Non-current Liabilities 0 0 Minority Interests 0 0 Members’ Equity Allocated Preferred stock 288 320 Common stock 89 90 Equity certificates 22,387 19,589 Unallocated capital 1,751 ______ 1,728 ______ Total Member Equity 24,515 ______ 21,727 ______ Total Liabilities and Equity 61,283 57,652 3
  9. 9. Table 2—Farmer Cooperative’s operating statement for years ended Dec. 31, 2001 and 2000 2001 2000 Dollars Revenues Marketing sales 73,513 76,700 Farm supply sales 46,710 ______ 46,053 ______ Total Sales 120,223 122,753 Cost of sales 98,474 ______ 106,057 ______ Gross Margin 21,749 16,695 Other operating revenues ______0 ______0 Total Operating Revenue 21,749 16,695 Expenses: General and administrative 11,850 10,263 Operating 2,759 ______ 2,836 ______ Net Operating Income 7,139 3,596 Other Revenues (expenses): Patronage refunds received 483 348 Interest income 162 120 Other income 31 107 Interest expense (1,493) (2,095) Other expenses ______0 ______0 Net Income, Continuing Operations 6,322 2,076 Other margin interests 0 0 Discontinued operations 0 0 Extraordinary items ______0 ______0 Net Income Before Taxes 6,322 2,076 Taxes ______8 35 ______ Net Income to be Distributed 6,314 2,041 during the business cycle. Cooperatives generate equi- Data from a cooperative’s financial statements tf y rom several sources, including net income, issuance reveal the company’s financial condition. Examining of stock, and per- n t c p t l re a n . ui aia tis common-size statements, cash flows, and financial ratios provides management, members, and creditors a glimpse of the cooperative’s strengths and weaknesses. Financial Statement Analysis The value of a particular ratio compared with a targ t e range of values indicates the firm’s financial health, The amount of information contained in a coop- and also identifies potential problem areas. Analysis erative’s financial statements is voluminous, spanning can also indicate areas of mismanagement and poten- the cooperative’s internal operations, its relationship tial danger. with the outside world, and its relationship with its As with all analytical methods, common-size member/patrons. To be useful, this information must statements, cash flow data, and financial ratios must be organized into an understandable, coherent, and be used in the light of other relevant facts. Also, the s fficiently limited set of data. Financial statement u analyst must remember that financial statements are a analysis can be beneficial in this respect because it “snapshot” of a firm at a particular point in the past. In highlights a firm’s strengths and weaknesses. a highly seasonal industry, conclusions drawn through 4
  10. 10. Table 3—Farmer Cooperative’s statement of cash flows for years ended Dec. 31, 2001, and 2000 Adjustments to reconcile net margins to net cash flows from operating activities — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — 2001 2000 Dollars Net Margins From Operations 6,314 2,041 Depreciation and amortization 2,759 2,836 Deferred taxes 0 0 Loss (Gain) from asset disposal 7 (4 7) Loss (Gain) from investment disposal 0 0 Patronage refunds received, (non-cash) (232) (221) Other cash adjustments 0 0 Other non-cash operating adjustments ______0 ______0 Cash From Operating Activities 8,848 4,582 Cash Provided (Used) by Changes in Assets and Liabilities Receivables 1,419 89 Inventories (1,022) 7,345 Other current assets (9 5) 88 Accounts pay 7,124 (4,188) Due patrons 0 0 Ohrcretlaiiis te urn iblte 946 81 Other assets and liabilities ______0 ______0 Net Cash Flow Operations 17,256 ______ 7,997 ______ Net Cash Flow Discontinued Operations ______0 ______0 Net Cash Flow Operating Activities 17,256 7,997 Cash Flows From Investing Activities: Purchases property, plant, and equipment (6,113) (4,162) Proceeds sale or disposal PP&E 9 76 Purchases, equity in cooperatives (284) () 1 Redemptions equity in cooperatives 0 11 Change in other investing activities () ______9 131 ______ Net Cash Flow Investing Activities (6,396) (3,946) Cash Flow From Financing Activities: Net change in short-term liabilities 0 0 Long-term bank debt Proceeds 40,964 47,848 (Payments) (49,930) (49,858) Capital lease payments 0 0 Stock transactions Proceeds 3 1 (Redemptions) (6 3) () 7 Per-unit capital retains 0 0 Equity certificates issued 0 0 Equity certificates redeemed 0 0 Cash patronage refunds (1,732) (2,007) Stock dividends (2 2) (8 2) Other financing adjustments ______0 ______0 Net Cash Flow From Financing Activities (10,753) ______ (4,051) ______ Net Change Cash and Equivalents 106 0 Cash at Beginning of Year ______7 ______7 Cash at End of Year 113 7 Supplemental Information Interest paid 1,697 2,056 Income taxes paid 26 () 5 5
  11. 11. Table 4—Farmer Cooperative’s statement of changes in allocated patronage refunds and capital reserve for years ended Dec. 31, 2001 and 2000 Unallocated Allocated Equity Equity Dollars Balance - Dec. 31, 1999 1,567 19,701 Net Margins 2,041 Net Margins Allocated to Patrons (1,922) 1,922 Transfer 71 (1 7) 7% Dividend on Stock (9 2) Patronage Distributions paind in cash 40 percent 2000 Patronage Refund (738) Allocated Patronage Revolvement ______ (1,225) ______ Balance - Dec. 31, 2000 1,728 19,589 Net Margins 6,314 Net Margins Allocated to Patrons (6,253) 6,253 Transfer (6 1) 16 7% Dividend on Stock (2 2) Patronage Distributions paind in cash 40 percent 2000 Patronage Refund (2,477) Allocated Patronage Revolvement ______ (993) ______ Balance - Dec. 31, 2001 1,752 22,387 ratio analysis might depend greatly on the period Common-sizing can also be used within sub- being analyzed. Historical comparison adds to any groups on the financial statements. For example, it analysis. may be of interest to know both the percentage of cash to current assets as well as the percentage of cash to Common-size Statements total assets. Knowing both provides a better under- When analyzing financial statements, it is helpful standing of the cooperative’s liquidity. to determine the proportion that a single account item In the case of the income statement, common-size represents of a group or subgroup total. This works analysis is a very useful tool, perhaps more important especially well for comparing various sizes of coopera- than the analysis of the common-size balance sheet. tives. In a balance sheet, total assets is expressed as 100 The income statement lends itself to this form of analy- percent. Each item in a common-size balance sheet is s s E c i e i i i related to a central quantity, t a i. ah tm n t s ht expressed as a percentage of the total assets. Similarly, i , s l s With some exceptions, such as some adminis- s ae. in the income statement, total net sales is set at 100 tration and overhead, the level of each revenue and percent and all other items are expressed as a percent- expense is dire t y related to the level of sales. Thus, it cl a e o n t s l s Tables 5 and 6 illustrate the common- g f e ae. i i s ructive to know what proportion of the sales dol- s nt size balance sheet and income statement for Farmer lar is absorbed by the various costs and expenses Cooperative. incurred by the cooperative. The analysis of common-size financial statements The use of common-size financial statements for may best be described as structural. In the analysis of comparing cooperative financial performance over the balance sheet, the structural analysis focuses on time is valuable in focusing on changing proportions several important aspects. What is the capital structure of components within a gro p o a s t , l a i i i s rev- u f ses iblte, of the cooperative? (E.g., how much of the coopera- enues, expenses, and other financial categories. tive’s assets is financed by current liabilities, long-term However, one must be careful in interpreting liabilities, and member equity?) And what is the distri- changes. For example, the percentage of accounts bution of the cooperative’s assets (current, fixed, and receivable to total assets could show an increasing other)? Put another way, what is the mix of assets the t rend. Yet, the actual dollar value of accounts receiv- cooperative uses to conduct operations? able might be the same and the increase in the percent- age is caused by a decline in total assets, e.g., because 6
  12. 12. Table 5—Farmer Cooperative’s common size balance sheet for year ended Dec. 31, 2000 and 2001 Assets 2001 2000 Percent Current assets Cash and equivalents 02 . 00 . Accounts receivable 19.7 23.4 Inventories 35.6 36.1 Other current assets 05 . ______ 05 . ______ Total Current Assets 56.1 60.0 Investments Bank for Cooperatives 60 . 56 . Other cooperatives 08 . 08 . Other businesses 00 . 00 . Other investments 00 . ______ 00 . ______ Total Investments 68 . 64 . Net plant, property and equipment 36.6 33.1 Other assets 05 . ______ 05 . ______ Total Assets 100.0 100.0 Liabilities and Members Equity Cretlaiiis urn iblte Current portion long-term debt 20 . 31 . Seasonal notes and loans 00 . ______ 15.9 ______ Total Short-term Liabilities 20 . 19.0 Trade accounts payable 33.2 23.0 Cash payments to members 40 . 13 . Patron and pool liabilities 00 . 00 . Ohrcretlaiiis te urn iblte 33 . ______ 18 . ______ Total Current Liabilities 42.6 45.1 Long-term Debt 17.4 17.2 Other Non-current Liabilities 00 . 00 . Minority Interests 00 . 00 . Members’ Equity Allocated Preferred stock 05 . 06 . Common stock 01 . 02 . Equity certificates 36.5 34.0 Unallocated capital 29 . ______ 30 . ______ Total Member Equity 40.0 ______ 37.7 ______ Total Liabilities and Equity 100.0 100.0 7
  13. 13. Table 6—Farmer Cooperative’s common size operating statement for year’ ended Dec. 31, 2001 and 2000 s Assets 2001 2000 Percent Revenues Marketing sales 61.1 62.5 Farm supply sales 38.9 ______ 37.5 ______ Total Sales 100.0 100.0 Cost of sales 81.9 86.4 Gross Margin 18.1 13.6 Other operating revenues 00 . ______ 00 . ______ Total Operating Revenue 18.1 13.6 Expenses: General and administrative 99 . ______ 84 . ______ Operating 23 . 23 . Net Operating Income 59 . 29 . Other Revenues (expenses): Patronage refunds received 04 . 03 . Interest income 01 . 01 . Other income 00 . 01 . Interest expense (.) 12 (.) 17 Other expenses 00 . ______ 00 . ______ Net Income, Continuing Operations 53 . 17 . Other margin interests 00 . 00 . Discontinued operations 00 . 00 . Extraordinary items 00 . ______ 00 . ______ Net Income Before Taxes 53 . 17 . Taxes 00 . ______ 00 . ______ Net Income to be Distributed 53 . 17 . of lower fixed assets or a write-off of investments. creditor may perceive the cooperative is in a less liquid Because a proportion can change either in the absolute position—unaware the cooperative is preparing for amount of the item or in the total of the group of additional seasonal demand by purchasing early to which it is a part, the interpretation of a common-size gain preseason discounts in the current year. The statement comparison requires an examination of the lender perceives that the uncharacteristic incre s i a ae s actual figures and the basis on which they are comput- sign of old inventory left over from the prior season, e. d leading to obsolete goods and future s l s l s e . ae oss In other situations, the loan officer may not have Analysis of Cash Flow a clear understand of the concept of pooling. The cred- While managers and financial officers know the itor may see low profitability ratios and deny the loan cash flow and earnings potential for their cooperative, because they do not believe the cooperative can gener- many potential creditors might not. Most look at the ate enough revenue. But a cooperative operating on a financial statements of the cooperative and pick out pooling basis may show higher cost of goods sold specific information to determine if the cooperative because of the way margins are distributed at the end can repay a loan. of the year. For example, if inventory levels uncharacteristi- It is imperative that the cooperative inform clyic a l n rease without a corresponding rise in sales, the lenders about the nature of its business and the back- 8
  14. 14. ground behind sudden changes in financial position. If tually lead to the drying up of trade credit. In such left to an inexperienced or uninformed lender, t e h cases, a lack of cash flow from operations has a diffr-e cooperative may not receive its anticipated loan. ent implication. There a several key cash-related early warning re The next SCF category is cash flows from invest- signs of financial difficulties. In addition to looking at ing activities. Most businesses must reinvest cash in ratios, lenders often look at changes in various o e t remain viable. The largest cash flows fro m rd r o accounts over time. They want to see if there a any re investments, by far,a those in property, plant, and re major changes or slow erosions taking place. In other equipment (PP&E). For the past 5 years, PP&E pur- words, is the liquidity of the cooperative going to be a chases represented 92 percent of total cash outlays for problem before t e l a i repaid? Bankers look for h on s investments of the largest 100 agricultural coopera- early warning signs, including: continued reliance on a tives. Cash flow from investing activities generally is ln o c i e f redit, overd a t , i c r f s n reases in inventory and/or negative, but not always. If a cooperative sells capital receivables, patronage refunds and other payments to a s t o receives significant patronage refunds, the ses r members greater than earnings, and a history of poor value could be positive. However, a cooperative that cash flow from operations. Most of these changes are resorts to selling capital assets or productive capacity evident or can be determined from the SCF. to generate a positive cash flow cannot do so indefi- The SCF sheds light on the effects earning activi- ntl i e y. ties have on cash resources and financing of the coop- Cash flow from financing activities varies erative. It helps clarify the distinction between “report- t remendously from year to year. Most inflows and out- ed net income” and “cash provided by operations” flows are e t e f i h r rom proceeds or from repayment of —two diffrent concepts. Net income can be mislead- e long-term debt. Between 60 and 70 percent of both ing because it is influenced by several estimated val- cash inflows and outflows from the 100 largest agricul- us(.. dp e i e , e reciation schedules, bad debt expense, tural cooperatives since 1987 weref rom these two cate- and inventory valuation). Cash flow is “real cash” gories. However, i t e t f h rend for the cooperative is a flowing in and out due to operations, investing, and continuous inflow of cash from financing and the financing activities. Consequently, cash flow should cooperative is not expanding, then a closer look is war- never be confused with net income. ranted. For example, if the cooperative is using exter- The ability of an enterprise to consistently gener- nal funds to purchase capital assets, it is investing in aecs f t a h rom operations is an important indicator of the future. On the other hand, if it is using external financial health. No cooperative can survive the long funds to finance operations, the cooperative could be term without generating cash from operations. While a heading toward a l q i i y c i i . iudt rss cooperative can inflate cash flows through both financ- After looking at all those sources of cash—opera- ing and investment, operations must keep the coopera- tions, investment, and financing—a creditor can get an tive financially viable in the long run. The interpre a- t idea of where the cooperative is heading financially. tion of cash flow from operations and re a e t l t d rends Table 7 illustrates some general guidelines on where t o must be made with care and a full understanding of all focus the analysis. An analyst should look at the trends crcumstances. i and the magnitude of change over the years and not Prosperous as well as failing entities may find just a single year of information. themselves unable to generate cash from operations at Above all, the SCF must be approached with care . any given time, but for diffre t reasons. The entity e n The analyst must understand the concept of cash flo w caught in the prosperity squeeze of having to invest its and other non-cash expenses in relation to net income. c s i receivables and inventories to meet ever- ah n If not, the analyst may be trapped by the numerous ic n reasing customer demand will often find that its cliches and useless generalizations, which are a l t o l o profitability will facilitate financing by equity and often employed even by those who should know better. debt. That same profitability should, ultimately, t r un cash flow from operations into a positive figure . Ratio Analysis The unsuccessful entity might find its cash Ratios are the most widely used tools for finan- drained by slowdowns in receivables and inventory cial analysis. Yet, their function is often misunder- turnovers, by operating losses, or by a combination of stood, and, consequently, their significance may easily these factors. These conditions usually contain the be overrated. seeds of further losses and cash drains that may even- A ratio expresses the mathematical relationship between two quantities. The ratio of 200 to 100 is 9
  15. 15. Table 7—Cash flow analysis Scenario –––––––––––––––––––––––––––––––––––––––––––––––––——————––––––––––––––––––––––– 1 2 3 4 5 6 7 8 Cash From Operation + - + + - - + - Cash From Investment + + - + - + - - Cash From Financing + + + - + - - - ( ) increase in cash flow + (- decrease in cash flow ) Scenario 1 The cooperative is using cash flow from all three areas (operations, investments, and financing) to build up cash reserves. The cooperative . may be looking for acquisition. This position is not stable in the long run. 2 The cooperative is subsidizing its operations through debt/equity and selling off parts of its investments. This situation is not stable in the . ln rn og u. 3 The cooperative is expanding its operation, using the positive cash flows from operations and financing to expand its capital base. This . scenario is stable. 4 The cooperative is selling off its assets and using the cash from operations to pay off member equity/debt. However, the cooperative can . not keep selling off its investments and survive in the long run. This is a stable scenario in the short run. 5 The cooperative could be expanding operations because of increased business or business could be in a downturn. Either way, it is not a . stable long-term position. This scenario is indeterminate. 6 The business is contracting and the cooperative is selling off its investments to fund operations and retire its equity/debt. This situation is . ntsal. o tbe 7 The cash flows from operations are funding capital expansion and debt/equity retirement. This scenario shows very strong operations and . i sal. s tbe 8 The cooperative is drawing down its cash reserves and may face liquidity problems in the near future. This situation is not stable. . expressed as 2:1 or 2. While the computation of a ratio the normal course of a business cycle. Long-term credi- involves a simple arithmetical operation, its interpre a- t tors and member/owners, on the other hand, are con- tion is far more complex. cerned with both the long-term and short-term out- The ratio must expre s a relevant relationship. s look. Management will also find ratios useful in For example, there i a c e r,drect, and understand- s la i measuring its own performance. a l relationship between the sales price of an item be As a final note of caution, the analysis of ratios is and its cost. On the other hand, there i n re l re a- s o a l useful only when all influencing factors are interpreted tionship between salaries and investments in other skillfully and intelligently. T i i , b f r, the most dif- hs s y a cooperatives. ficult aspect of ratio analysis. Look at a simple exam- Ratios are analysis tools that provide clues to p e relating to a non-financial problem. In comparing l help identify symptoms of underlying conditions. the ratio of gas consumption to mileage driven, driver Analysts, depending on their needs, may diff r i t e e n h A claims to be more e fficient than driver B (i.e., A gets ratios they find useful when examining a cooperative’s 30 mpg and B only gets 20 mpg). Assuming that both financial position. Short-term creditors are primarily drive the same car, it would appear that driver A is i t rested in the cooperative’s current performance ne more e fficient. However, other facts should be consid- and its holdings of liquid assets that can provide a e d re : ready source of cash to meet current cash require- G weight of the load carried, ments. These assets include cash, marketable securi- G type of terrain (flat versus hilly), ties, accounts receivable, inventory, and other assets G city or highway driving, and which can be sold for cash or can become cash through G speed at which the car was driven. 10
  16. 16. All of these driving factors influence gasoline used more p roductively. If too small, the firm may be efficiency. In financial analysis, the same premise providing poor service to customers or ineff c e t y iinl holds. The ratios should be used as a tool to help find producing products. srengths and weaknesses but, other factors should t There a two basic approaches to the computa- re also be considere . d tion of activity ratios. The first looks at the average performance of the firm over the year. The second uses Standard Financial Ratios—Four categories of year-end balances in the calculations. r t o a typically used in analyzing financial a i s re The first method is pre e red if asset balances fr position: fluctuate significantly during the year. For example, G Liquidity inventory levels for most fruit and vegetable coopera- G Leverage tives vary significantly, depending on the time of the G Activity season. If the fiscal year ends before the harvest, when G Pro i a i i y ftblt inventories are low, calculations using year-end bal- ances will be biased and the resulting ratios will be of Liquidity ratios measure t e a i i y t f l i l h blt o ufl little value for comparing between diffrent coopera- e short-term commitments with liquid assets. Such tives. The second method is the most commonly used r t o a of particular interest to the cooperative’s a i s re approach because in practice, data limitations often short-term creditors. These ratios compare assets that f rce outside analysts to use year-end data. o can be converted to cash quickly to fund maturing Profitability ratios measure the success of the short-term obligations. The current ratio and the quick firm in earning a net return on its operations. Pro i i ft s r t o a the two most commonly used measure o l q- a i re s f i an important objective of a cooperative, so poor per- uidity. For most cooperatives, these two ratios provide formance indicates a basic failure t a , i n t c r h t f o o rected, a good indication of liquidity. However, these ratios do would probably result in the firm going out of busi- not address the quality of liquid assets. ness. Cooperatives must operate profitably, although Leverage ratios measure the extent of the firm’s their definition of profitable might diff r f e rom an “total debt” burden. They reflect the cooperative’s IOF’s. Hence, appropriate profitability ratios pose the ability to meet both short- and long-term debt obliga- biggest challenge for analyzing cooperatives. tions. The ratios are computed either by comparing Patronage refund policies have a dramatic eff c et earnings from the income statement to interest pay- on cooperative profitability ratio analysis. Some coop- ments or by relating the debt and equity items fro m e a i e return patronage at the end of the operating rtvs the balance sheet. Creditors value these ratios because year and show significant profits on the closing state- they measure the capacity of the cooperative’s rev- ments. Other cooperatives have diffrent operational e enues to support interest and other fixed charges, and policies and may show little end-of-the-year pro i sft. indicate if the capital base is sufficient to pay off t e h Lending institutions not familiar with these businesses debt in the event of liquidation. may shy away from cooperatives with low reported In terms of debt load, the more p redictable the net income. This will be especially true for pooling returns of the firm, the more debt will be acceptable, cooperatives that generally report a minimum amount because the firm will be less likely to be surprised by of income at year-end. crcumstances that prevent fulfilling debt obligations. i Common ratios used to analyze the four are s o a f F r e a p e u i i i s ( . . rural electric cooperatives) o xml, tlte ie, financial performance can be found in most basic have historically had relatively stable incomes, but are financial textbooks and were developed to analyze a also among the industries with the heaviest debt struc- wide variety of businesses. Most of these ratios are t re B c n r s , f u . y o t a t ruit and vegetable cooperatives are applicable to the cooperative form of business, while in a cyclical business, where income is greatly influ- others should be viewed with some reservation. enced by weather conditions, and they normally carry a far lower proportion of debt in their capital structure . Interdependence of Ratios—Ratios must be Activity ratios show the intensity with which the evaluated together, not independently. A firm may firm uses assets in generating sales. These ratios indi- have low liquidity ratios, but more than adequate cate whether the firm’s investment in current and leverage, interest coverage, and pro i a i i y r t o . ftblt ais long-term assets is too larg , t o s a l o j s r g t I e o ml, r ut ih. f This firm would be in a good position to obtain t o l rge, funds may be tied up in assets that could be o a additional long-term funds, and in the process, pay down short-term debt or purchase liquid assets. This 11
  17. 17. firm would improve its liquidity ratios while main- managerial control can change. Each change has an taining adequate levels of the remaining performance effect on the firm’s performance. Ratios analyzing measure. s these changes provide feedback to management. A The net operating margin (net margin/sales) will thorough analysis of the performance ratios regarding be used to further illustrate the interdependence managerial policies in effect at each period of time between ratios. Knowing the value of the net operating may guide future policy decisions. margin without knowing the level of sales is not too Another reason to look at historical performance helpful. The net operating ratio may be lower than the of a cooperative is to avoid the difficulties encountered industry average, but this might be because the firm when comparing two similar cooperatives. Although has cut margins to increase total sales. The result may comparisons should be between like firms, generally, be that the firm’s return on assets is extremely high for no two firms are exactly the same. the industry, i t e f r s i c f h i m n reased sales are s ff c e t u iin While two farm supply cooperatives may be of to compensate for the lower return per dollar of sales. similar size, one may sell mostly bulk feed with lower Consider this example: margins, while the other sells more agronomy prod- ucts, which typically carry higher margins. Also, Net margins Net margins Sls ae boards may vary on their philosophy on the ideal capi- — — — — — — = — — — — — — x — — — — — t l s ructure. One cooperative may be debt-free but the a t Ttl ast oa ses Sls ae Ttlast oa ses another cooperative board might feel that returns fro m leveraging the cooperative outweigh the risk of acquir- In this example, if the net operating marg n i i s ing the debt. low and the assets turnover ratio (sales/assets) is high, return on total assets may be high. Consequently,a low operating margin due to a price cut policy that Ratios for Cooperatives ic n reases sales may prove to be a very profitable situa- to. in There a some inherent problems associated re Similarly, the net operating margin may be high with some common ratios used in cooperative finan- but the return on total assets may be poor. This occurs cial analysis. Some problems are intrinsic with the when the firm has excess operating capacity and con- ratios themselves and some are with the cooperative sequently a high level of non-performing fixed assets. sructure. For instance, the current ratio is used to ana- t However, more information is needed to understand lyze liquidity.I p t rovides a good benchmark for deter- whether or not this is a good situation for the coopera- mining whether a cooperative has liquid assets to tive. For example, this may be the case where t eh cover current payments. However, i t r reting these nep firm’s business is contracting and could benefit by sell- ratios beyond the conclusion that it represents current ing off unused facilities or by using the remaining resources over current obligations at a given point in fixed assets more e i i n l On the other hand, the ff c e t y. time requires a more in-depth look at the trends of the firm may experience a tremendous increase in sales individual parts that make up the ratio. A curre t r t o n ai and is expanding its production facilities beyond their doesn’t show the quality of the liquid assets which can current needs, expecting to grow into the facilities in g a l a e t t e “ rue” liquidity. re t y ff c h t the future. Profitability ratios can also be deceiving. As men- tioned earlier, cooperatives are generally not proi ft Trends over time—Historical information can be motivated. They are more concerned toward serving very beneficial when analyzing financial performance. member-owners. There o f re, low profit ratios can be When analysis reveals certain weaknesses in a misleading to the analyst, especially with some pool- cooperative’s financial health, the initial management ing cooperatives. reaction may be to take immediate action to corre t t e c h This next section looks at limitations and tries to situation. However, i h s o i a t f i t r c l rend analysis remedy the shortcomings of common ratios. Along indicates the situation is improving, the best remedy with each ratio, a table illustrates the values from the may be to monitor performance for continued database of the largest agricultural cooperatives. These improvement—in other words, don’t overre c . at values are p resented to show an order of magnitude. Historical trends are important for other reasons The average values and the high and low correspond- as well. During the life of the firm, pricing, cre i p l d t o i- ing to the 95 perc n i e a included in the table. These e t l re cy,production methodology, and other areas under 12
  18. 18. ratio values might not relate to the optimal value for Table 8—Days to sell inventory efficient operations, but have value for comparison 95 Percent Confidence Interval purposes. — — — — — — — — — — — — — — — — Average High Low Data The ratios were developed from financial data Al l 49 57 40 taken from 113 cooperatives across an 18-year period— Cotton 63 98 27 1980-97. When two or more cooperatives merged, no Dairy 19 26 11 attempt was made to estimate the financial statements Diversified 44 49 39 as if they had merged prior to the point of merger. Farm Supply 41 52 30 Once a cooperative ceased to exist, either through Fruit/Vegetable 105 136 74 merger or through cessation of operations, it was no Grain 46 55 37 longer included in the database. A ratio for each coop- Poultry/Livestock 4 8 0 erative was computed from 18 years of data. If the Rice 90 134 45 cooperative was less than 18 years old, the total num- Sugar 58 78 38 ber of years the cooperative was in service was used. These values were then averaged. Conversion Period of Inventories turnover ratio. This ratio provides insight into how Creditors must be concerned not only with the many days the average inventory sits on the shelf or in current liquidity position of the firm, but also with its storage. Usually a lower value is better (Ta l 8 . be ) overall financial position. The current or quick ratios The use of average monthly inventory is pre e f r- alone do not tell the whole story. A firm with adequate able to taking the beginning and ending inventory liquidity ratios might be a greater threat to short-term divided by two. Many cooperatives end their fiscal creditors if its liquidity is tied up in uncollectible year when inventory levels are at their seasonal low. accounts receivable or outdated inventory. However, This will suppress the value. Due to limited informa- this does not imply that liquidity ratios areirelevant. r tion, these values are calculated by taking the begin- On the contrary, a higher liquidity ratio is generally ning and ending inventory levels divided by two. pre e re . fr d However, 360 days is an arbitrary number. Most A look at the quality of the current assets indi- businesses have fewer than 360 working days. But, cates how well the cooperative can meet current oblig- using a standardized number allows comparisons ations. The average cooperative has more than 75 per- between diffrent time periods and cooperatives. e cent of current assets tied up in inventories and I alslsa c s , t i p f l a e re a h h s rocedure gives the num- accounts receivable, so the asset quality warrants clos- ber of days to convert inventory to cash. However, two er examination. One way to examine the liquidity of more steps are needed if there a c re redit sales—calcu- = accounts receivables and inventories is to calculate the late the days in accounts receivable and add that value conversion period of inventories. to days in inventory.To calculate this ratio, use the Although not a cooperative-specific ratio, the average accounts receivable divided by the total cre idt conversion period of inventories is used to analyze the sales for the year multiplied by 360 days. As with the quality of the least liquid current assets—inventory days to sell inventory, the days in accounts receivable and accounts receivable. The value represents the aver- is 360 days divided by accounts receivable turnover age number of days it takes to convert inventories into ( be9. Ta l ) cash. The ratio is calculated in three steps. Each step is I t e t i step, the conversion period is calcu- n h h rd important on its own. lated by adding the days to sell inventory and days in The first step is to determine the number of days accounts receivable. Although using cre i s l s t dt ae o it takes to sell inventory. This is calculated by dividing determine days in accounts receivable is more accu- the average inventory by the cost of goods sold multi- rate, total sales works without more detailed informa- plied by 360 days or 360 days divided by the inventory Average Inventory Average accounts receivable Dy t sl ivnoy = as o el netr — — — — — — — — * 360 days Days in accounts receivable = (— — — — — — — — — — — — )* 360 days Cs o gossl ot f od od Cei sls rdt ae 13
  19. 19. Table 9—Days in accounts receivable Payout Ratio This ratio measures the proportion of current and 95 Percent Confidence Interval — — — — — — — — — — — — — — — — past earnings returned to members during the year, Average High Low looking only at total cash disbursements. The numera- tor consists of all cash payments to members. This is important because the equity portion of cooperatives is Al l 27 30 24 not static. This ratio examines the equity revolvement Cotton 17 20 14 Dairy 26 28 23 and dividend policy. Diversified 42 66 17 A value of less than 1 indicates the cooperative is Farm Supply 30 36 23 growing its equity position or not revolving member Fruit/Vegetable 36 48 24 equity, while a value of greater than 1 implies a shrink- Grain 20 24 17 ing of its equity base. While this ratio is important to Poultry/Livestock 22 40 4 alc l reditors, those with a long-term stake should look Rice 32 39 24 a tet t h rend during the past few years to see if the Sugar 25 31 19 cooperative’s at-risk capital is being maintained (Table 11. ) tion. If a distinction between credit and cash sales can Cash patronage dividends + other be made, the following weighted average formula dividends + revolving equity redeemed should be used: Payout Ratio = — — — — — — — — — — — — — — — — — — — N et margins This value should help management and credi- tors gauge liquidity of the cooperative’s inventory and accounts receivable. If the cooperative has a substan- t a p rcentage of current assets tied up in these two il e accounts, then a high ratio number implies the cooper- Table 11—Payout ratio ative’s current position might not be very liquid (Table 95 Percent Confidence Interval 1) 0. — — — — — — — — — — — — — — — — Average High Low Percent Cash Sales * Days to Sell Inventory +Percent Credit Sales * (Days to Sell Inventory +Days in Accounts Al l 0.59 0.66 0.51 Receivable) Cotton 0.85 0.99 0.71 — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — Conversion Period of Inventories Dairy 0.72 0.84 0.60 Diversified 0.23 0.44 0.01 Farm Supply 0.46 0.61 0.32 Fruit/Vegetable 0.66 0.88 0.44 Grain 0.42 0.52 0.31 Table 10—Conversion period of inventories Poultry/Livestock 0.47 0.62 0.31 Rice 0.61 0.90 0.33 95 Percent Confidence Interval Sugar 0.63 1.00 0.25 — — — — — — — — — — — — — — — — Average High Low Al l 75 84 67 Cotton 80 116 44 Capitalization Growth Rate Dairy 44 52 37 The payout ratio can further determine the capi- Diversified 86 114 57 talization growth rate of the cooperative. In other Farm Supply 71 84 58 Fruit/Vegetable 141 169 113 word , c s reditors and members may want to forecast Grain 66 75 58 the growth of the cooperative’s at-risk capital base. Poultry/Livestock 26 45 7 This will show whether the cooperative can continue Rice 121 165 78 revolving member equity and still maintain the equity Sugar 83 99 68 base to ensure enough capital to satisfy cre i o s dtr. 14