Issue 11
Jan./Feb. 1998

16 Factors that Assess your
Farm's Financial Health

by Tracy Sayler


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Prairie Grains is the
official publication of
the Minnesota
Association of
Wheat Growers,
North Dakota Grain
Growers Association,
South Dakota Wheat,
Inc., and the
Minnesota Barley
Growers Association.


The farm lending community realized there was a lesson to be learned from the farm debt crisis of the 1980s: methods used to determine, measure and analyze the financial position and performance of farms were either seriously underused, or woefully inadequate.

Thus, in 1988 the ag lenders division of the American Bankers Association proposed that farm lending guidelines should be standardized. Finding a common ground to report and analyze farm finances would not only reduce risks for farmers and lenders nationwide, but also improve farm finance education, and permit the collection of data for historical and comparative analysis of farming operations.

A "Farm Financial Standards Task Force," which later became the Farm Financial Standards Council, approved a report in 1991 that established universal financial reports, criteria, measurements, and data collection procedures for farm finances.

Following are factors derived from the report for use by producers, agri-businesses, and financial institutions, to adequately measure the financial position and performance of farms. Since every farming operation is different, not every measurement may be used for assessment, and additional measures may be used if they provide more insight.

In any case, farm lenders use many of these financial performance ratios (what some call the "Sweet Sixteen") to assess farm financial health. The 16 factors fall under five categories: Liquidity, Solvency, Profitability, Repayment Capacity, and Financial Efficiency. For an illustration of actual performance ratios, see the chart of farms enrolled in the Northland Farm Business Management on the bottom of this page.

Liquidity:

Factors that measure dollars available to purchase inputs and inventory items after the sale of current farm assets and the payment of all current liabilities.

1) Current Ratio -- (total current farm assets divided by total current farm liabilities). Virginia Tech Ag Economist David Kohl, who played a key role in developing the 16 farm performance ratios, would like to see a current ratio of at least 1.5 for single enterprises, and 1.25 for multi-enterprises. Unhealthy, according to Kohl's guidelines, is a single-enterprise ratio lower than 1.0, and .75 for multi-enterprises.

2) Working Capital -- (total farm assets - total farm liabilities). This is one of the more critical factors, since it measures the amount of operating capital available for the farm operation. Deferred taxes should be included as liabilities. This factor ignores committed lines of credit, and does not recognize current assets that cannot be liquidated instantly.

Solvency:

These factors evaluate what would happen if all assets were sold and converted to cash and all liabilities were paid.

3) Debt To Asset Ratio -- Measures farm debt relative to the value of the farm (total farm liabilities divided by total farm assets). It measures the proportion of farm assets financed by debt as opposed to owner's equity. This ratio is greatly influenced by the value placed on the assets. Although a reasonable standard for the ratio varies by enterprise, Kohl suggests that a ratio less than 30% as optimal; less than 70% as acceptable; anything greater than 70% unsatisfactory.

4) Equity To Asset Ratio -- (total farm equity divided by total farm assets). Measures farm equity, or net worth. Not all lenders may calculate both the debt-to-asset ratio and the equity-to-asset ratio, preferring to use one or the other (Further, since these two ratios added together always equal 100%, calculating both is unnecessary) . Under Kohl's guidelines, an equity-to-asset ratio greater than 70% is optimal; 30%-70% acceptable; and under 30% unsatisfactory.

5) Debt To Equity Ratio -- (total farm liabilities divided by total farm equity). Measures your ability to leverage borrowed money, or farm debt relative to farm equity. A ratio under 45% would be optimal, 45% to 230% acceptable, and over 230% unsatisfactory. Area lenders place more emphasis on the debt-to-asset and equity-to-asset ratios.

Profitability:

Most crucial in evaluating the level of success of a farming operation. Following are key indicators in evaluating net farm income.

6) Rate Of Return On Assets - -The interest rate earned on all investments in the farm business. For market value assets, this can be looked at as the "opportunity cost" versus alternative investments. How it is calculated: Net farm income from operations (NFIFO, excluding gains and losses from disposal of farm capital assets) + farm interest expense - value of operator and unpaid family labor and management divided by average total farm assets. Optimal is a rate of at least 8%; below 3% is unsatisfactory.

7) Rate of Return on Equity -- Interest rate being earned on your farm equity. For market value assets, this return can be compared to returns available if the assets were liquidated and invested in an alternative investment. Rate of return on farm equity should be greater than return on farm assets when borrowed money or credit is used. A rate of 5 to 15% would be acceptable; more than 15% is optimal and less than 5% is unsatisfactory.

8) Operating Profit Margin -- (NFIFO + farm interest expense - value of operator and unpaid family labor and management) divided by gross revenue). Measures the operating efficiency of the business. If expenses are held in line relative to the value of output produced, the farm will have a healthy profit margin. Not only may low prices cause a low profit margin; high operating expenses and inefficient production can also contribute. Further, a farm can generate profit but not cash flow- the culprits being debt or living expenses that are too high. A rate of return of at least 25% is optimal; less than 10% is too low.

9) Net Farm Income -- The return to labor, management, and equity capital in the business. A key factor, this is the reward for investing unpaid family labor, management, and farm equity in the farm business instead of elsewhere.

Repayment Capacity:

The first ratio in this category provides a measure for the borrower to cover all term debt and capital lease payments, and the second to measure capital replacement and term debt repayment margin.

10) Term Debt Coverage Ratio -- Measures whether the business (nonfarm income included) generated enough cash to cover term debt payments. A key measurement because if the number isn't positive it will be difficult for a lender to approve additional credit. A ratio less than 100% indicates that the business did not generate sufficient cash to meet scheduled payments in the past year.

11) Capital Replacement Margin -- Calculates cash generated that is available for financing capital replacement items such as equipment.

Financial Efficiency:

Includes five ratios for evaluation, profitability, operating efficiency, competitiveness, and level of profits retained in the business.

12) Asset Turnover Ratio -- (gross revenue divided by average total farm assets). This measures efficiency in using capital, and is a comparison between the value of farm production and total farm assets. If the business generates a high level of production with the given level of investment, the asset turnover rate will be high. Rate may vary by style of capital ownership.

13) Operating Expense Ratio -- (operating expenses, excluding interest and depreciation) divided by gross revenue or value of farm production). This ratio indicates the percent of gross farm income that was used to pay operating expenses. Lenders prefer to compare on a five-year history, and again, need to consider the style of operation. For example, a person who rents or leases equipment will have a higher operating expense ratio than a farm with owned assets. A ratio of less than 65% is optimal, 65% to 80% acceptable, and over 80%, a red flag.

14) Depreciation Ratio -- (depreciation expense divided by gross revenue). Can vary depending on the method of depreciation used. A management depreciation is recommended, since it is a steady measurement as opposed to tax-based, which can vary from year to year.

15) Interest Expense Ratio -- (interest expense divided by gross revenue). Measures the amount of farm income used to pay interest which should be calculated on an accrual basis. Optimal is an interest expense of 7% or less; More than 15% is unacceptable.

16) Net Farm Income Ratio -- (net farm income divided by gross revenue). Indicates the percent of gross farm income remaining after all expenses for living, tax needs, capital purchases, investment, retirement, or debt payments. A ratio of 15% or more is optimal; less than 5% unsatisfactory.

"If anything, these factors are just a benchmark. Obviously, good records are needed for the 16 measurements to be accurate. Weather, prices, and other circumstances can be subjective, and need to be considered. For example, it's understandable for a young start-up producer to have a high debt-to-asset ratio, but not so for the guy who's been farming for 35 years. The key is to look at these factors in combination and over a period of time, and look at the trend for where operational changes may be needed," says Ron Dvergsten, farm business management instructor with Northland Community Technical College.

Being Prepared For Your Lender

What should you as a borrower do to be prepared in approaching a lender? The American Bankers Association suggests that if you can respond to the 12 questions below and provide support for your answers, you will have gone a long way toward being adequately prepared.

  1. How much money are you going to need?
  2. What is the money going to be used for?
  3. How will the loan affect your financial position?
  4. How will you secure the loan?
  5. How will you repay the loan?
  6. When will the money be needed and when will it be repaid?
  7. Are your projections reasonable and supported by documented historical information?
  8. How will alternative possible outcomes affect your repayment ability?
  9. How will you repay the loan if the first repayment plan fails?
  10. How much can you afford to lose and still maintain a viable operation?
  11. What risk management measures have been or are to be implemented?
  12. What have been the trends in the business's key financial position and performance indicators?
Copyright Prairie
Grains Magazine January 1998
 

Farm Financial Ratios
Average of all farms
Average of low 20%
Average of high 20%
1994
1995
1996
1994
1995
1996
1994
1995
1995
LIQUIDITY
Current Ratio
1.47
1.3
1.53
0.85
0.7
1.15
1.8
1.83
1.72
Working Capital
36,941
27,535
52,288
-11,759
-38,471
8,737
114,770
118,268
166,213
SOLVENCY RATIOS (Market)
Farm Debt to Asset
43%
45%
43%
60%
64%
52%
32%
33%
37%
Farm Equity to Asset
57%
55%
57%
40%
36%
48%
68%
67%
63%
Farm Debt to Equity
74%
83%
76%
153%
181%
111%
47%
49%
59%
PROFITABILITY (Market)
Rate of Return on Farm Assets
6.20%
5.20%
10.00%
-4.90%
-3.80%
-1.90%
12.40%
10.00%
15.10%
Rate of Return on Farm Equity
5.80%
3.90%
12.30%
-20.50%
-21.00%
-11.30%
15.00%
11.50%
20.00%
Operating Profit Margin
17.10%
15.00%
24.60%
-15.50%
-11.50%
-7.40%
33.00%
28.00%
33.30%
Net Farm Income
35,325
29,975
63,501
-21,195
-32,746
-7,668
131,350
105,704
205,095
REPAYMENT CAPACITY (Accrual)
Term Debt Coverage Ratio
106%
75%
185%
-71%
-77%
55%
222%
200%
248%
Capital Replacement Margin
1,296
-7,472
28,739
-37,863
-67,919
-8,520
47,142
42,635
102,517
EFFICIENCY
Asset Turnover Ratio (Market)
36.20%
35.10%
40.90%
31.60%
32.80%
25.70%
37.60%
35.70%
35.70%
Operating Expense Ratio
74.90%
77.60%
68.90%
100.00%
103.60%
88.40%
64.80%
64.80%
64.30%
Depreciation Expense Ratio
4.40%
4.40%
3.60%
9.50%
7.10%
9.20%
2.00%
3.70%
2.20%
Interest Expense Ratio
7.30%
8.30%
7.30%
11.00%
12.90%
11.60%
5.50%
6.10%
6.10%
Net Farm Income Ratio
13.00%
9.00%
20.20%
-17.20%
-22.00%
-9.30%
27.00%
24.30%
27.40%
Actual farm financial measurements of 300 to 400 farms that participated in the Northland Community Technical College (Thief River Falls, MN) farm business management program between 1994 and 1996.