Measuring & Analyzing Financial Performance

ANALYZING FINANCIAL POSITION AND PERFORMANCE Analyze Financial Statement information Learn two basic types of analysis Use five key financial criteria Learn how to calculate key financial measures

TWO TYPES OF ANALYSIS 1.Comparative statement analysis 2.Financial ratio analysis The purpose of both types of analysis is to: FIND, LOCATE AND ISOLATE

RATIOS Monitoring Tools Used in conjunction with other information Rules of thumb are only guidelines Unlimited number of - physical ratios -financial ratios Take time to develop - a “feel” - understand - internalize

RATIO ANALYSIS Trends over time Compare to industry standards Comparison to similar firms Comparison to performance objectives

FINANCIAL RATIO ANALYSIS Types of ratios to look at: Liquidity: Measures ability to meet obligations when due without disrupting normal operations Solvency: Measures borrowed capital in relation to owner’s equity capital invested in the business

FINANCIAL RATIO ANALYSIS (cont’d) Profitability: Measures amount of profit from use of labor, management and capital Repayment Capacity: Measures ability to repay debts from both farm and non-farm income Financial Efficiency: Measures degree of efficiency in use of labor, management and capital

TESTS OF LIQUIDITY A. Working Capital = B. Current ratio = C. Acid test ratio = D.Cash flow coverage ratio = Total current farm assets minus total current farm liabilities Current assets Current liabilities Liquid assets Current liabilities Cash available 1 Cash required 2 1 Beginning cash + cash received from operating activities+ cash received from investing activities + proceeds from term loans + cash received from equity contributions 2 Cash paid for operating activities + cash paid for investing activities + principal paid on term loans and capital leases + cash equity distributions

TESTS OF SOLVENCY A. Debt-to-assets = B. Equity-to-assets ratio = C. Debt-to-equity ratio = total liabilities total assets total farm equity total farm assets total farm liabilities total farm equity

TESTS OF PROFITABILITY A. Return on equity = net income from farm operations - value of unpaid labor/management average owners equity B. Return on assets = net income from farm operations interest expense - value of unpaid labor/management total farm assets C. Operating profit margin ratio = net farm income from operations + farm interest expense - value of unpaid labor/mgmt gross farm revenues

REPAYMENT OF CAPACITY RATIOS Term debt and capital lease coverage ratio = net farm income from operations + total non-farm income + depreciation/amortization expenses + interest on term debt + interest on capital leases - total income tax expense- withdrawals for family living annual scheduled principal and interest on term debt + annual scheduled principal and interest on capital leases Debt-to-income ratio = average total farm liabilities net farm income from operations

FINANCIAL EFFICIENCY RATIOS A. Asset turnover ratio = gross farm revenue average total assets B.Operating expense ratio = total expenses (excl. int. & depr. expense) gross farm revenues C.Depreciation expense ratio = depreciation expense gross farm revenue D.Interest expense = total farm interest expense gross farm revenue E.Net farm income = net farm income from operations from operations ratio gross farm revenues

OTHER EFFICIENCY RATIOS Labor productivity ratio = gross farm revenues labor and salary expense + value of unpaid labor and management Machinery and equipment productivity ratio = gross farm revenues avg. investment in farm machinery and equip.

OTHER COMPARISONS Carrying charge on owned land vs. Cash rental rate on comparable loan Family withdrawal as a percent of - value of farm production - total expenses Machinery investment per acre Nonproductive assets as a percent of total assets

COMPARING RATIOS 1. Net income, is it ✧ before or after taxes ✧ cash or accrual ✧ farm or farm plus non-farm ✧ before or after family living withdrawls 2.Balance sheet and resulting net worth ✧ cost, market or something in between ✧ have accrued items been included or omitted ✧ are deferred tax liabilities included or omitted 3.Is the information based on the individual, the business or a combination of the two 4.Is the ratio based an average, beginning of the year or end of the year figures

COMPARING RATIOS (cont’d) 5. The legal structure of the entity - corporation vs. proprietorship - treatment of salaries vs. withdrawals 6.Same fiscal year or point in time 7.What are you comparing to - industry, state average, or loan portfolio average... - a specific farm category, size 8.Type of business - dairy vs. grain vs. cattle 9.Are the firms from the same geographic area: - production methods (seasonality, irrigated vs. dry land, confinement vs. pasture, double vs. single crop)

CASE STUDY Ahmed and Zainab own and farm 130 dunum. On 100 tilled dunum, they grow 65 dunum of wheat and 35 dunum of barley. They also cash rent 500 dunum (320 dunum of wheat and 165 dunum of barley) and rent 400 dunum (200 dunum of wheat and 200 dunum of barley) on a share lease. So, in year 2004 they farmed 585 dunum of wheat and 400 dunum of barley. They also sold 550 goats. Ahmed and Zainab work full time on the farm and have one hired man who works for them full time.

Ending Balance Sheet Name: Ahmed & Zainab Farmer 1,000 Iraqi Dinars Date: December 31, 2004 ASSETSLIABILITIES AND OWNER EQUITY CostMarket ValueCostMarket Value Current assetsCurrent liabilities Cash Livestock: Goats Grain inventory: Wheat Barley Supplies Other ID 14,297 32,560 88,800 22,200 4,943 0 ID 14,297 32,560 88,800 22,200 4,943 0 Accounts payable Operating loan Portions of term debt due in 12 mo: Machinery loan Real estate loan Accrued interest: Accounts payable Operating loan Machinery loan Real estate loan Accrued taxes: Real estate Income & SS Other ID 23, ,600 8,880 4,440 2,457 6,216 2, ,776 0 DI 23, ,600 8,880 4,440 2,457 6,216 2, ,776 0 Total current assetsID 162,800 Total current liabilitiesID 153,920 Non-current assetsNon-current liabilities Machinery: Cost Acc. Dep. Breeding livestock: Purchased Raised Land & Buildings Cost Acc. Dep. Other ID 177,600 57,720 2,960 10, ,520 20,720 0 ID 139, ,880 2,960 10, ,760 Total non-current assetsID 296,000ID 355,200Total non-current liabilitiesID 102,120 Total liabilitiesID 256,040 Owner equityID 202,760 Total assetsID 458,800ID 518,000Total liabilities and owner equityID 458,800ID 518,000

1 Beginning cash + cash received from operating activities + cash received from investing activities + proceeds from term loans + cash received from equity contributions 2 Cash paid for operating activities + cash paid for investing activities + principal paid on term loans and capital leases + cash equity distributions Analyzing financial performance for Ahmed and Zainab Farmer 1.Using information from Ahmed and Zainab’s 2003 and 2004 market-value balance sheets, 2003 income statement, 2003 statement of cash flows, 2003 cash flow statement and reconciliation of owner equity, calculate the following measures of financial performance.

A. Working capital= B. Current ratio= C. Cash flow coverage ratio= D. Debt-to-asset ratio= E. Equity-to-asset ratio (percent ownership) = total current farm assets less total current farm liabilities current assets current liabilities cash available¹ cash required² total liabilities total assets total farm equity total farm assets ID 16,280, N/A ____________ _

F. Debt-to-equity ratio (leverage)= G. Rate of return on assets= H. Rate of return on equity= I. Operating profit margin ratio= total farm liabilities total farm equity net income from farm operations + int. expense -value of unpaid labor/management total farm assets net income from farm operations -value of unpaid labor/management average owners equity net farm income from operations+farm interest expense -value of unpaid labor/mgmt gross farm revenues 1.03 NA ______________

J. Term debt and capital lease coverage ratio= K. Debt-to-income ratio= net farm income from operations+farm interest expense -value of unpaid labor/mgmt gross farm revenues net farm income from operations+ total non-farm income +depreciation/amortization expenses+interest on term debt+interest on capital leases-total income tax expense - withdrawals for family living annual scheduled principal and interest on term debt +annual scheduled principal and interest on capital leases NA ______________

L. Asset turnover ratio= M. Operating expense ratio= N. Depreciation expense ratio= O. Interest expense ratio= P. Net farm income from operations ratio= total farm equity total farm assets total farm liabilities total farm equity net income from farm operations + int. expense -value of unpaid labor/management total farm assets net income from farm operations -value of unpaid labor/management average owners equity NA ______________

Exercise (cont’d) 2.Compare Ahmed and Zainab’s working capital and current ratio on December 31, 2003, with those measures on December 31, Are Ahmed and Zainab Farmer more or less liquid in 2004 than in 2003? 3.Compare Ahmed & Zainab’s 1.2% rate of return on assets to your calculated rate of return on equity. What does the relationship imply about the Farmers’ use of borrowed capital?

Exercise (cont’d) 4.What are the Farmers’ debt-to-asset ratios on December 31, 2003, and December 31, 2004, using the cost method of valuing assets? Are the ratios higher or lower than the ratios calculated for 2003 and 2004 using the market-value method? 5.The total of Ahmed and Zainab’s operating, depreciation and interest expenses as a percentage of gross farm revenues in 2004 equals _____%. If that amount is added to net farm income from operations/gross farm revenues, the total equals _____%.

Summary TESTS OF LIQUIDITY TESTS OF SOLVENCY TESTS OF PROFITABILITY TESTS OF REPAYMENT CAPACITY TESTS OF EFFICIENCY OTHER MEASURES PECULIAR TO THE TYPE OF OPERATION