MF270 Financial Ratios Used in Financial Management
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MF270 Financial Ratios Used in Financial Management

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MF270 Financial Ratios Used in Financial Management MF270 Financial Ratios Used in Financial Management Document Transcript

  • Farm Management Guide MF-270 Financial Ratios Used in Financial Management Department of Agricultural Economics — www.agmanager.info Kansas State University Agricultural Experiment Station and Cooperative Extension Service Michael R. Langemeier Professor, Agricultural Economics Financial aspects of the farm business have rapidly flow statement, see Cash Flow Projection for Operating Loan increased in importance in recent years. Farm business size Determination, MF-275. has increased. Cash expenses have gone up. Larger amounts The income statement is a listing of the receipts and the of credit are being used. expenses of a business, including depreciation, and the result- As the size of an operation increases and credit use is ing net income for a specific period. Allowance is made for expanded, financial management becomes more critical to changes in inventories. Net farm income is equal to receipts the success of the operation. More sophisticated accounting minus expenses plus or minus the change in inventories. For systems are needed to furnish farm financial management more detail on the income statement, see Farm Management information. This calls for tools to aid in interpreting the Guide MF-294, Income Statement — A Financial Management accounting figures. This is where financial ratios come in. Tool. The actual data used in this guide was obtained from Non-agriculture businesses have used financial ratios to MF-291, MF-275, and MF-294. interpret data from financial reports for many years. When Financial ratios can be put to many uses. They may be investments in farm businesses were small, the need for this used by a farm operator or business manager in managerial type of analysis was minimal. With the magnitude of today’s analysis; they also may be used by a lending agency in credit farm businesses, financial ratios can aid in converting the analysis; and they may be used by an investor in investment mass of data that is common in an effective farm accounting analysis. system into meaningful information. A number of useful ratios have been found to be indica- A financial ratio is simply a comparison of two measure- tors of farm financial progress and risk-bearing ability. These ments of a business to each other. For example, a measurement ratios can be grouped into five categories: of income may be compared to a measurement of size. The • Liquidity two measurements are expressed in terms of a ratio of one • Solvency number to another number. The measurements can also be • Profitability expressed in terms of the percent that one is to another. For • Financial Efficiency example, a farm business with a net farm income of $50,000 • Repayment Capacity and a value of farm production of $250,000 has a net farm income to value of farm production ratio of 1:5. Expressed Liquidity Indicators in percentage terms, this same farm business has a net farm Liquidity measures the ability of a farm business to meet income that is 20 percent of the value of farm production. financial obligations as they come due in the ordinary course Data for financial ratios come from the balance sheet, the of business, without disrupting the normal operations of the cash flow statement, and the income statement. business. The current ratio and working capital measure The balance sheet is a listing of the assets and liabili- liquidity and can be calculated using balance sheet data. ties of the business and the resulting equity on a given date. The Current Ratio indicates the extent to which current Equity is the difference between the assets and the liabilities. farm assets, if liquidated, would cover current farm liabilities. For more detail on the balance sheet see Farm Management The higher the ratio, the greater the liquidity. Guide MF-291, Balance Sheet — A Financial Management Tool. Total Current Farm Assets A cash flow statement records the dollars going in and the Current Ratio = Total Current Farm Liabilities dollars going out of a business. It shows where the money comes from — the inflow of cash — and where the money Example: 284,794 ÷ 188,238 = 1.51 (1.51:1) goes — the outflow of cash. For more detail on the cash Financial Management 3—Revised December 2009
  • Working capital is a measure of the amount of funds avail- The Debt/Equity Ratio measures financial position and able to purchase inputs and inventory items after the sale of reflects the extent to which farm debt capital is being com- current farm assets and payment of all current farm liabilities. bined with farm equity capital. The higher the ratio value, The amount of working capital considered adequate is related the more total capital has been supplied by creditors and to the size and type of farm business. less by the owner. Total Farm Liabilities Debt/Equity Ratio = Working Capital = Total Current Farm Assets – Total Total Farm Equity Current Farm Liabilities Example: 416,800 ÷ 692,132 = 0.6022 (60.22%) Example: 284,794 – 188,238 = $96,556 Profitability Indicators Current farm assets are those assets that “turn over” in Profitability measures the extent to which a farm business a normal year’s operation. Examples are crops held for sale generates a profit from the use of land, labor, management, or feed, livestock held for sale, cash on hand, and accounts and capital. Financial ratios and values that measure prof- receivable. Current liabilities are debts that come due within itability are calculated from balance sheet and income the year, including notes due within the year, accrued expenses, statement data, and include: the current portion of deferred taxes, and the portion of non- • Rate of Return on Farm Assets current debt due in the present year’s business. • Rate of Return on Farm Equity • Operating Profit Margin Ratio • Net Farm Income from Operations Solvency Indicators The Rate of Return on Farm Assets Ratio is often used as Solvency measures the amount of debt and other expense an overall index of profitability of the farm business. The obligations used in the farm business relative to the amount higher the ratio value, the more profitable the farm business. of owner equity invested in the business. Solvency ratios provide an indication of the business’s ability to repay all Rate of Return on Farm Assets = financial obligations if all assets were sold, as well as an (Net Farm Income from Operations + Interest Expense - indication of the ability to continue operations as a viable Unpaid Family Labor) ÷ Average Total Farm Assets farm business after a financial adversity, such as a drought. Financial ratios that measure solvency are calculated from Example: (85,239 + 19,074 – 47,370) ÷ 1,074,187 = 0.0530 balance sheet data, and are: (5.30%) • Debt/Asset Ratio • Equity/Asset Ratio The Rate of Return on Farm Equity Ratio provides a • Debt/Equity Ratio measure of the return on the owner’s equity capital employed The Debt/Asset Ratio compares total farm liabilities to in the farm business. The higher the ratio value, the more the value of total farm assets, and therefore measures finan- profitable the farm operation. cial position. This ratio expresses what proportion of total Rate of Return on Farm Equity = farm assets is owed to creditors. The ratio is one measure (Net Farm Income from Operations – Unpaid Family of the risk exposure of the farm business; thus, is important Labor) ÷ Average Total Farm Equity in evaluating the financial trend of the business. The goal of many farm business operators is to approach a debt free Example: (85,239 – 47,370) ÷ 668,483 = 0.0566 (5.66%) operation. A continual lowering of this ratio is a trend in that direction. The higher the ratio, the greater the risk exposure The Operating Profit Margin Ratio measures profitability of the farm business. in terms of return per dollar of value of farm production. A Total Farm Liabilities farm business has two ways to increase profits — either by Debt/Asset Ratio = Total Farm Assets increasing the profit per unit produced, or by increasing the volume of production if the farm business is profitable. A Example: 416,800 ÷ 1,108,932 = 0.3759 (37.59%) relationship exists between the rate of return on farm assets, the asset turnover ratio, discussed below, and the operating The Equity/Asset Ratio measures the proportion of total profit margin ratio. If the asset turnover ratio is multiplied farm assets financed by the owner’s equity capital, and there- by the operating profit margin ratio, the result is the rate of fore indicates financial position. The higher the ratio value, return on farm assets. the more total capital has been supplied by the owner and less by creditors. Operating Profit Margin Ratio = Total Farm Equity (Net Farm Income from Operations + Interest Expense - Equity/Asset Ratio = Total Farm Assets Unpaid Family Labor) ÷ Value of Farm Production Example: 692,132 ÷ 1,108,932 = 0.6241 (62.41%) Example: (85,239 + 19,074 – 47,370) ÷ 355,001 = 0.1604 (16.04%)
  • NOTE: Value of farm production is defined as the Net Farm Income from Operations total sales of crops, market livestock, other farm receipts, Net Farm Income Ratio = Value of Farm Production breeding livestock adjustment, and accrued income adjustment minus market livestock purchases minus feed Example: 85,239 ÷ 355,001 = 0.2401 (24.01%) purchased plus or minus the change in crop and market livestock inventories. NOTE: Gross revenues, rather than value of farm pro- duction, can be used to calculate the financial efficiency and Net Farm Income from Operation is calculated by matching operating profit margin ratios. farm revenues with farm expenses incurred to create those revenues. Net farm income from operations is typically com- Repayment Capacity Indicators puted on a before-tax basis. Repayment capacity measures are used to determine whether a farm has the ability to cover principal and interest Example: $85,239 payments, and evaluate the farm’s ability to acquire capital and service additional debt. Financial Efficiency Indicators Income Available for Capital Replacement and Term Debt Financial efficiency measures the intensity with which a Repayment can be used to examine a farm’s repayment capac- farm business uses its assets to generate value of farm produc- ity. This measure should be compared to projected capital and tion and the effectiveness of production, purchasing, pricing, term debt payment needs. financing, and marketing decisions. Financial efficiency ratios are calculated from balance sheet and income statement data, Income Available for Capital Replacement and Term Debt and include the following ratios: Repayment = [Net Farm Income from Operations + Total • Asset Turnover Ratio Nonfarm Income + Depreciation Expense – Taxes Paid – • Operating Expense Ratio • Depreciation Expense Ratio Unpaid Family Labor] • Interest Expense Ratio Example: (85,239 + 12,042 + 28,118 – 6,412 – 47,370) = • Total Expense Ratio $71,617 • Net Farm Income Ratio The Asset Turnover Ratio measures how efficiently farm assets are being used to generate revenue. The higher the value of the ratio, the more efficiently assets are being used Uses of Financial Ratios to generate revenue. The value of this ratio will vary by type The establishment of minimum or maximum ratio values of farm operation. that all farm businesses should meet for each financial ratio is extremely difficult. One objective in the use of financial Value of Farm Production Asset Turnover Ratio = ratios is to evaluate the condition of a farm business as a unit. Average Total Farm Assets A specific ratio concentrates attention upon specific details Example: 355,001 ÷ 1,074,187 = 0.3305 (33.05%) of the business. The use of a single ratio or placing excessive emphasis on one ratio, may be misleading. For example, an The five operational ratios reflect the relationship of operator who has just started a farm business may have a debt/ expense and income categories to value of farm production. asset ratio that is much higher than an operator who has built The sum of the first three operational ratios equals the total the farm business over a longer time span. The young opera- expense ratio. The sum of total expense ratio and net farm tor, even though of equal ability, compares his/her debt to a income ratio is one. much smaller asset base. But, this same young operator may Total Operating Expense – show a more desirable rate of return to assets than his/her Depreciation Expense counterpart, again because of the smaller asset base. Operating Expense Ratio = The interpretation of one ratio may be altered by other Value of Farm Production ratios of the same business. Some lending institutions, farm Example: 222,570 ÷ 355,001 = 0.6270 (62.70%) operators and farm advisors have selected a group of ratios that they believe give a composite picture of the farm busi- Depreciation Expense ness. The calculated ratios of a specific farm business are Depreciation Expense Ratio = Value of Farm Production then interpreted as a group, rather than making judgements on individual ratios. Example: 28,118 ÷ 355,001 = 0.0792 (7.92%) Another objective in the use of financial ratios is to detect strengths and weaknesses within a farm business. Interest Expense Comparison of ratios of a farm business to ratios of other Interest Expense Ratio = Value of Farm Production farm businesses of similar type may detect strengths or Example: 19,074 ÷ 355,001 = 0.0537 (5.37%) weaknesses. Comparing to established standards is helpful. Comparison of ratios of a farm business to earlier years also gives indication of progress made within the business. Total Farm Expense A good agricultural accounting system should result in an Total Expense Ratio = Value of Farm Production income statement, cash flow statement, and a balance sheet Example: 269,762 ÷ 355,001 = 0.7599 (75.99%) report of the farm business. Values needed in calculating each
  • of the above ratios are listed on these three reports. Once 5. Financial ratios of a specific business are best inter- the accounting system provides the data, the ratios can be preted as a group, rather than making judgments on calculated in a matter of minutes. individual ratios. 6. Individual ratios may be used to detect strengths Summary and weaknesses within a farm business. As farm business size increases and credit usage goes up, For further information on farm financial management a means of evaluating the condition of the farm operation see the following Farm Management guides: as a business unit becomes more critical. Financial ratios MF-275 Cash Flow Projection for Operating Loan provide one method of interpreting data in farm financial Determination reports. The following guidelines furnish a framework for MF-291 Balance Sheet — A Financial Management Tool using financial ratios: MF-294 Income Statement — A Financial Management 1. A financial ratio is a comparison of two measure- Tool ments of a business. The objective is to evaluate the condition of the farm business as a unit. Also, see the publication Financial Guidelines for 2. Data for most financial ratios come from the bal- Agricultural Producers, Recommendations of the Farm ance sheet, the income statement, and the cash flow Financial Standards Council, Revised, January 2008, which statement. was used as one of the primary sources for this guide. 3. Financial ratios are useful indicators of financial The Kansas Farm Management Association Web site, progress and risk-bearing ability. www.agmanager.info/kfma, contains financial ratio summary 4. The interpretation of one ratio may be altered by information by farm size, farm type, and farm management other ratios of the same business. association. These summaries also contain information per- taining to value of farm production, net farm income, labor efficiency, and production. Publications from Kansas State University are available on the World Wide Web at: www.ksre.ksu.edu Contents of this publication may be freely reproduced for educational purposes. All other rights reserved. In each case, credit Michael R. Langemeier, Financial Ratios Used in Financial Management, Kansas State University, December 2009. Kansas State University Agricultural Experiment Station and Cooperative Extension Service MF-270 December 2009 K-State Research and Extension is an equal opportunity provider and employer. Issued in furtherance of Cooperative Extension Work, Acts of May 8 and June 30, 1914, as amended. Kansas State University, County Extension Councils, Extension Districts, and United States Department of Agriculture Cooperating, Fred A. Cholick, Director.