Understanding financial ratios is a key component to your operation's success. When you visit the doctor's office and they take your blood pressure, the nurse usually rattles off a number: "115/75." You may look at them and ask, "Well, is that good or bad?" You can think of financial ratios with the same mindset, they measure your financial health.
Understanding financial measures and ratios will help you better understand the shape your operation is in and what you can do to improve or capitalize on it. The following measures and ratios are popular when dealing with a lender:
You will likely hear lenders discuss working capital more than any other portion of your balance sheet. This is simply your current assets minus your current liabilities. Working capital indicates the liquidity of your business, or rather, your “skin in the game.” These numbers are found in the top third of your balance sheet.
- Current assets include cash on hand, crop and market livestock inventory, hedging accounts, prepaid expenses, and accounts receivable. Anything that can be converted to cash within 12 months is considered a current asset.
- Current liabilities include accounts payable, operating loans and lines of credit, and any accrued interest and term payments due within 12 months.
Working capital is also viewed as your safety net in times of shortfalls or low margins during financially stressful years and provides flexibility when opportunities present themselves, like that quarter of land you've been wanting to buy for the last 20 years.
Working Capital to Gross Revenues
This measures the operating capital available against business size. To calculate, take working capital divided by gross revenues . Every operation is different, and this measure is used to develop a better picture of individual operations, rather than just analyzing straight dollar amounts of working capital. For example, $1 million in working capital might be a lot for a 1,000-acre farm that generates roughly $850,000 in gross revenues. But for a 15,000-acre farm that generates roughly $12,787,500 in gross revenues, $1 million in working capital is not enough in the eyes of a lender. The ratios are 118% and 8%, respectively. The higher, the better this ratio.
Debt Coverage Ratio
Knowing whether your operation generated enough income to cover current interest expenses and all intermediate and long-term debt payments is important. That is exactly what this ratio does. Your operation may have an A+ report card for profitability, but if you have too many debt obligations, your operation will go backward trying to meet those obligations. This ratio is calculated by taking net farm income from operations (minus income taxes and owner withdrawals) divided by total debt repayment obligations. When looking at your own operation, where does this ratio stand? If your ratio is 0.88, it can be read as “you had 88 cents to pay back every dollar of debt.” The higher ratio the better for this one. Anything over one means you could meet your debt obligations and still have change left in your pocket.
Owner Equity Ratio
Gauging a farmer’s ownership or share in the business can be a key indicator of financial health. This ratio compares total farm debt to total farm assets. Typically, a lender would like to see this ratio at 0.50 or greater when an operator is looking for financing. Other factors do come into play, such as age and outside support, but 50% owner equity is a good rule of thumb.
Operating Expense Ratio
This ratio isn't a huge driver in big credit decisions for a lender, but it is a good tool to measure efficiency. The operating expense ratio shows the proportion of farm income used to pay operating expenses, minus depreciation and interest expense. This is calculated by taking total operating expenses minus depreciation and amortization and dividing it by gross farm revenue. Look at your own operation. Do you have a ratio closer to 0.72 or 1.05? What do these numbers mean? If your ratio is 0.72, it can be translated to you spending 72 cents to make one dollar. The lower ratio, the better.
At the end of each fiscal year, compare your operation’s ratios to the prior year and understand the trends. There isn’t just one ratio to indicate a successful operation, but rather a combination of numbers. Understanding what these numbers tell you will set you apart from your neighbors.
Get a complete understanding of your ratios by contacting your loan officer or visiting your local AgCountry office.