Financial Analysis II
Financial Analysis II ABM 122
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Date Created: 10/15/15
Study Guide Financial Ratios Financial Ratios are an important tool that allows those inside and outside of a business to evaluate business performance in an objective fashion Ratios can be used to assist in decision making and goal setting for the business owner as well as to help identify symptoms of underlying problems and to measure progress over time Lenders find ratios helpful in evaluating the business credit risk In the late 1980 s The Farm Financial Standards Council FFSC was developed to look into the feasibility of standardized financial statements for producers to use when analyzing their business Part of their mission was to identify measures of financial position and performance for farm and ranch businesses and to recommend the most accurate method of calculating each of those measures They adopted 16 financial measures broken down into five critical areas Liquidity Solvency Profitability Financial efficiency Repayment capacity The Task Force recommended guidelines for calculating and interpreting each of the financial measures but did not establish numerical standards Their recommendation was that farmersranchers use these measures to develop trends and to compare results with other similar operations when that information is available Farm Credit Services has established some benchmarks for their borrowers and presents them in terms of green yellow and red lights These benchmarks will be included in the discussion below A green light represents low risk a yellow light indicates moderate risk and a red light corresponds to high risk A green light doesn t guarantee success nor does a red light imply that the business will fail as there are many issues that need to be taken into account in the analysis of any business Talk with your lender about what benchmarks she uses to evaluate credit risk In the following section each of the categories and the associated ratios will be explored To help clarify the calculation of these ratios we will use the information for an example farm found in Tables 1 2 and 3 on pages 6 and 7 to calculate each ratio Liguidityithis is defined as measure of the ability of a farm business to generate sufficient cash to meet financial obligations as they come due in the next 12 months without disrupting or curtailing the normal operation of the business The two financial measures for liquidity current ratio and working capital are calculated from information found on the balance sheet Current Ratio current farm assets current farm liabilities Morgan Community College Ag and Business Management January 2005 This ratio is usually reported as a number compared to 17ie 1501 This is interpreted as for every 1 of current liabilities the business has 150 in current assets available to cover these commitments If the ratio is 11 then there is just enough current assets to cover current liabilities but there is no safety margin for price changes and other factors The larger the ratio the more liquid the business Farm Credit Services generally considers a ratio of greater than 150 to be a green light between 100 and 150 a yellow light and less than 100 a red light There are several factors that can impact the interpretation of a current ratio For example a dairy operation can manage with a lower ratio due to low inventories and a steady monthly income There will also be some variation in this ratio depending on the point in the production cycle A business that is attempting to improve the current ratio should start by looking at their loan structure If non current assets were being financed with current debt ie operating loan this would have a negative impact on the current ratio A second area to investigate would be to evaluate the marketing plan to better time cash in ows and out ows The Current Ratio for our example farm at the end of the year X1 would be 112500 88860 1271 ie the example farm has 127 of current assets to cover current liabilities Working Capital current farm assets current farm liabilities If you were to convert all your current assets to cash and pay off all current liabilities how much would you have left to continue operating Working capital is the owner s share of current assets and is reported as a dollar value not a ratio Because it is an absolute value working capital is difficult to use when comparing the liquidity of businesses of different sizes However it can be used by the individual business to develop a trend As working capital increases the exibility of the business in terms of marketing purchasing equipment and timing cash ows improves Working capital should increase over time unless there are special circumstances such as an expansion of the business The working capital for our example farm would be 112500 88860 23640 Solvencyithis addresses the relative relationship among assets liabilities and equity Solvency is ultimately a measure of the business s ability to repay all financial obligations if all assets are sold It is also used to predict the ability to of the business to continue to operate after a financial setback There are three ratios that the FFSC recommended and any of these ratios will when correctly computed and analyzed provide full information about solvency The three financial measures for solvency debtasset ratio equityasset ratio and debtequity ratio are calculated from information found on the balance sheet DebtAsset Ratio total farm liabilities total farm assets X 100 This ratio measures what part of total assets is owed to lenders and is expressed as a percentage As this ratio increases management exibility decreases and earnings are more stressed to service debt However a very low debt asset ratio may indicate that a manager is hesitant to use debt capital to take advantage of opportunities and thus is limiting hisher income potential A ratio of less than 30 is considered a green light 30 55 a yellow light and greater than 55 a red light Ideally this ratio should File Study Guide 7 Financial Ratios 2 Morgan Community College Ag and Business Management January 2005 decrease over time The DebtAsset Ratio for our example farm would be 368860 741500 x 100 50 EquityAsset Ratio total farm equity total farm assets X 100 This ratio measures what part of total assets is financed by the owner s equity capital Higher values are preferred but this ratio cannot exceed 10 An insolvent business would have a negative equityasset ratio because the owner s equity would be negative This ratio is the reverse of the debt to asset ratio If the debt ratio is 40 then the equity ratio is 60 A ratio of greater than 55 would be considered a green light 30 55 a yellow light and less than 30 a red light Ideally this ratio should increase over time The EquityAsset Ratio for our example farm would be 372640 741500 x 100 50 DebtEquity Ratio total farm liabilities total farm equity X 100 This ratio is also known as the leverage ratio and compares the proportion of financing provided by lenders with that provided by the business owner Smaller values are preferred and the debtequity ratio will approach zero as liabilities approach zero Very large values result from very small equity which means an increasing chance of insolvency A ratio of less than 42 is considered a green light 42 122 a yellow light and greater than 122 a red light Ideally this ratio should decrease over time The DebtEquity Ratio for our example farm is 368860 372640 x 100 99 A business that is trying to improve the solvency ratios should look at methods of increasing equity and reducing external financing Some strategies that might be considered are Increase profits though a combination of Increasing prices quality volume or adding value to production Improving production efficiencies Make additional principal payments where possible Avoid unnecessary capital expenditures Control family living expenditures Profitabilityithis compares business income against all costs and evaluates how productively a business is utilizing all its resources While a business can operate in the short term at or slightly below break even profits are necessary to support the family increase equity service debt and generally sustain the business Ratios are used to evaluate how much profit a business generates relative to the size of the business andor the value of the resources used to generate the profit To be meaningful the profitability measures must be calculated from an accrual income statement The ratios that measure profitability are rate of return on farm assets ROA rate of return on farm equity ROE and operating profit margin ratio and are calculated from information found on the income statement and statement of owner equity These measures use Net Farm Income From Operations NFIFO in the calculations NFIFO does not include the gains or losses from the sale of farm capital assets as these are generally large and infrequent and do not represent income generated by the use of assets in the normal production activities of the business File Study Guide 7 Financial Ratios 3 Morgan Community College Ag and Business Management January 2005 Rate of Return on Farm Assets ROA NFIFO interest expense owner withdrawals X 100 average farm assets This ratio analyzes how good of job the farm39s assets both capital and human are doing in producing profit and is expressed as a percentage Other terms used for this measure are return to capital or return on investment It is obtained by dividing the dollars earned by both debt and equity capital by the average dollar value of assets held for the year We start by adjusting net farm income from operations to account for borrowed money by adding back in the interest expense for the year We then subtract the money the owner withdrew over the year to account for unpaid labor and management To calculate the average total farm assets take the total assets from the beginning balance sheet add the total assets from the ending balance sheet and divide by 2 For a business that owns most of it s assets rather than renting a ROA ratio of greater than 5 is considered to be a green light 1 5 as a yellow light and less than 1 as a red light If the farm rents most of the land it farms or a significant amount of the machinery and equipment the ROA ratios would need to be higher for the business to remain competitive Our example farm s ROA is 46800 29500 7 36000 725750 x 100 555 Rate of Return on Farm Equity ROE gNFIFO owner withdrawals X 100 average farm equity This ratio measures how well the owner s investment in the business is generating income Again we adjust the net farm income from operations by subtracting the amount the owner has withdrawn from the business Average farm equity is calculated by adding the business equity figures from the beginning and ending balance sheets and dividing by 2 Because owner s equity levels can vary widely there are no benchmarks for analyzing ROE The producer should monitor the trends in this ratio over time This figure can be compared to the expected return on investments from non farrn investments such as mutual funds the stock market etc with comparable risks to decide if the operation s ROE is adequate The ROE for the example farm is 46800 36000 361320 x 100 299 Operating Profit Margin Ratio NFIFO interest expense owner withdrawals X 100 gross revenue This ratio looks at profits as a percent of total revenue generated Interest expense is added back in to the net farm income from operations to eliminate the effect of debt on operating profit This allows the operating profit margin ratio to focus strictly on the profit made from production without considering the debt level which can vary considerably from farm to farm By subtracting owner withdrawals the results can be compared to other businesses where labor and management is hired A ratio of 25 or greater is considered a green light 10 25 a yellow light and less than 10 a red light The example farm s Operating Profit Margin Ratio is 46800 29500 36000 200400 x 100 201 Financial Efficiency gEconomic Efficiency githis is a measure of the intensity with which a business uses its assets to generate gross revenues and the effectiveness of File Study Guide 7 Financial Ratios 4 Morgan Community College Ag and Business Management January 2005 production purchasing pricing financing and marketing decisions The ratios associated with this are operating expense ratio interest expense ratio depreciation expense ratio asset turnover ratio and the net income from operations ratio The information for calculating these ratios comes from the income statement Strategies to increase financial efficiency include 0 Monitoring and reducing production costs where possible and prudent Increasing the quality amount and value of production Improving the marketing of production Keeping owner s withdrawals to a minimum Making sure that debt is properly structured Operating Expense Ratio total expenses interest depreciation X 100 Gross revenue This is the key ratio used to measure financial efficiency The operating expense ratio answers the question How much does it cost to generate 100 of revenue It is calculated by dividing total operating expenses excluding interest and depreciation by gross revenue A ratio of less than 65 is a green light 65 80 a yellow light and greater than 80 of a red light A higher ratio is acceptable if a large portion of the farmranch is rented or leased Very large operations such as nurseries or feedlots typically can survive with higher ratios because they have large volume and small margins Regardless of size decreasing margins indicate increasing risk To lower the ratio the producer should focus on reducing the five largest expenses usually cropping feed labor interest and repairs reducing owner withdrawals and restructuring debt The example farm s operating expense ratio is 153600 7 29500 8200 200400 x 100 58 Interest Expense Ratio interest expense gross revenue X 100 This ratio measures the percentage cost of debt to the operation It is calculated by dividing interest expense by gross revenue If this ratio is high it may indicate too much borrowed capital or a high interest rate on debt Ratios that are less than 12 are a green light from 12 20 a yellow light and greater than 20 a red light For the example farm the interest expense ratio is 29500 200400 x 100 15 Depreciation Expense Ratio depreciation expense gross revenue X 100 This ratio measures the percentage cost of all depreciable assets such as machinery breeding livestock etc It is calculated by dividing depreciation expense by gross revenue Those operations with a large investment in newer machinery and equipment will have higher depreciation expense ratios Because of the diversity of farming operations and levels of equipment it is not possible to set any benchmarks for this ratio The depreciation expense ratio for the example farm is 8200 200400 x 100 4 Asset Turnover Ratio gross revenue average total farm assets X 100 File Study Guide 7 Financial Ratios 5 Morgan Community College Ag and Business Management January 2005 This ratio measures how efficiently farm assets are being used It is calculated by dividing the gross revenue by average assets This ratio will vary by the type of production Dairy hog and poultry farms will have higher rates while beef cattle operations will be lower and crop farms somewhere in between Those farmsranches that own most of their resources will have a lower ratio than those that rent land and other assets Therefore the asset turnover ratio should only be compared among farms of the same general type For our example farm the asset turnover ratio is 200400 725750 x 100 276 NFIFO Ratio NFIFO gross revenue This ratio measures a farm s profit margin This is how much is left after paying all expenses and it is calculated by dividing the net farm income from operations by the gross revenue There are no benchmarks available for this ratio but since profits are what allows the operation to expand and grow the higher this ratio the better Repayment CapacityiThis is a measure of the borrower s ability to repay term debts and capital leases while maintaining normal business activity The recommended measures include non farrn income so that the repayment capacity can be evaluated regardless of the source of the funds Term Debt amp Capital Lease Coverage Ratio NFIFO total nonfarm income depreciation expense interest on term debt interest on capital leases total income tax expense owner withdrawals annual scheduled principal amp interest payments on term debt amp leases This ratio is essentially the total cash available for debt payments divided by the total of the payments due Note that it does include off farrn income The greater the funds available to cover debt payments the more easily the operation can manage unforeseen expenses thus lowering risk A ratio greater than 150 is a green light 110 150 a yellow light and less than 110 a red light The lower the coverage ratio the more important risk management tools such as insurance marketing strategies etc become for the continued operation of the business Capital Replacement amp Term Debt Repayment Margin NFIFO total nonfarm income depreciation expense total income tax expense owner withdrawals payments on prior period unpaid operating debt principal payments on current portions of term debts principal payments on current portions of capital leases total annual payment on personal debt This is not really a ratio like working capital it is the difference between the money available and the total scheduled payments It is useful for analyzing several factors For example the importance of non farrn income can be measured by comparing off farrn income to the margin If the margin approaches zero or is negative when non farrn income is removed from the equation then the farm is heavily dependent on this source of income The margin should also be compared to depreciation expense lf depreciation is greater than the margin the business may have difficulty in replacing capital assets File Study Guide 7 Financial Ratios 6 Morgan Community College Ag and Business Management Finally an evaluation of how dependent the business is on support payments can be made by comparing total government payments to the margin Because this is an absolute number no benchmarks are available Table 1 Example Farm Balance Sheets Summary of Balance sheet for example farm 1231X0 Current Assets 101000 Current Liabilities 95000 Non current Assets 609000 Non current Liabilities 265000 Total Liabilities 360000 Owner Equity 350000 Total Assets 710000 Total Liabilities amp Equity 710000 Summary of Balance sheet for example farm 1231X1 Current Assets 112500 Accounts Payable 6000 Notes amp term debt 24160 Other current liab 58700 Total current liabilities 88860 Non current Assets 629000 Non current Liabilities 280000 Total Liabilities 368860 Owner Equity 372640 Total Assets 741500 Total Liabilities amp Equity 741500 Table 2 Statement of Owner Equity 1231X1 Owner equity 12 3 1X0 Net farm income for year X0 Less adjustment for income tax Net after tax income Less increase in current portion deferred tax Owner withdrawals from farm business Nonfarm income contributed to farm business Net owner withdrawals from farm business Other capital contributions to farm business Other capital distributions from farm business Increase in market value of farm assets Less increase in noncurrent deferred taxes Net increase in valuation equity Owner equity 1231X1 47900 8150 36000 9500 19990 8000 350000 39750 2600 26500 0 0 D O 119 372640 File Study Guide 7 Financial Ratios Morgan Community College Ag and Business Management January 2005 Table 3 Income Statement for example farm for year ending 1231X1 Revenue Cash sales Inventory changes Government program payments Change in accounts receivable Other farm income Total Gross Revenue Expenses Purchased feed amp grain Purchased market livestock Other cash operating expenses Adjustments Accounts payable Prepaid expenses Accrued expenses Depreciation Total Operating Expenses Cash interest paid Change in interest payable Total Interest Expense Total Expenses Net Farm Income From Operations NFIFO Gainloss on sale of capital assets Net Farm Income 202100 6300 3400 1200 12000 28000 73400 1000 1500 0 8 200 2 30000 5001 200400 124100 29500 153 600 46800 1 10 4790 00 File Study Guide 7 Financial Ratios Morgan Community College 7 Ag and Business Management 1 Study Guide Accrual Income Statements Introduction It is essential for a business to construct an income statement that shows the profit or loss it has incurred over a set period of time In contrast to a balance sheet which is prepared for one point in time an income statement is prepared to span the interval between two balance sheets In other words an income statement may cover a week month quarter or year Depending on the accounting software you may be able to even run an income statement for other time periods Accrual vs Cash lncome Statements There are two methods of recordkeeping cash basis and accrual basis Cash records show only whether an income was received or an expense paid While this is typically the method used for reporting income taxes cash method ignores revenues that have not been received accounts receivable and expenses that have not been paid accounts payable Additionally cash records may not match up the revenue from a particular period to the expense that was incurred to enable the revenue Examples would be to sell this year inventory that was produced last year The expense of producing the product is recorded in last year s expense but the income or revenue that was realized from the expenditure would be recorded in this year s records In order to analyze a business properly however we need to measure its financial success with accrual income statements But most agricultural and general businesses keep cash records because they use the cash method for reporting their income tax Accrual Adjustments One way to combine the features of a cash basis recordkeeping system and accrual is to use accrual adjustments to convert an income statement from cash basis to accrual The nature of these adjustments is to measure a change between two balance sheets and add or subtract that change to the cash income or expense you are measuring Essential Things to Know About Accrual lncome 0 Income tax documents prepared on a cash basis do not necessarily report the pro tability of a business They are prepared to calculate the income tax owed by the business Cash basis income tax documents include cash revenue and expense but also include non cash expense in the form of depreciation In other words we treat depreciation as an expense but we don t have to write a check for it An accrual basis income statement must be accompanied by an accrual basis balance sheet at the beginning and end of the period When constructed correctly these statements fit together If the statement period is different that the beginning or ending balance sheet an inaccurate analysis can result Some lenders and lending institutions derive an accrual basis income statement from two balance sheets and a copy of the business taxes In essence they work backward from the taxes and the balance sheets to determine what the business File Study Guide Accrual lncome Statementsdoc 1 Morgan Community College 7 Ag and Business Management income and expenses were on an accrual basis This is why it is imperative to also turn in to the lender a balance sheet dated at the end of the tax accounting period and to have turned one in at the beginning of the tax year as well Under the accrual accounting method revenue and expense are matched so that the revenue reported in a period is offset by the expense that was incurred in order to generate the revenue Cash expenses that are not used or consumed during a year become an asset on an end of period balance sheet This changes the amount of expense reported on an accrual basis Examples of this are items that are put into inventory such as consumable supplies and feed Similarly revenue that was earned but has not yet been received will be recorded on the end of period balance sheet in the form of accounts receivable The difference between cash and accrual basis net income can be quite substantial or it can be relatively minor The point is that you don t know what it is until you make the accrual adjustments Businesses that have long intervals between revenues tend to have greater differences between cash and accrual method than those that have short intervals Compare a diary farm that received payment every two weeks to a cattle ranch that sells calves once a year Or compare a custom home builder who is paid when the home is completed to a grocery store that deposits sales daily Accrual income analysis is very dependent on the quality and depth of detail of the balance sheets at the beginning and ending of period Over time the balance sheets will become more accurate When doing the accrual income analysis keep in mind that there are three potential sources of error the beginning balance sheet the cash income and expenses and the ending balance sheet Making an accurate accrual income statement is a necessary step in order to complete both the Statement of Cash Flows and the Reconciliation of Owner s Equity A series of accrual income statements can be used to establish a trend for key measures and ratios As with balance sheets one accrual income statement is useful but it is most useful when seen as one in a series of income statements that are developed in the same method and at the same level of detail File Study Guide Accrual lncome Statementsdoc
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