Financial Analysis Ag Management Chapter 3

Objectives Know the three kinds of financial analysis Be able to calculate liquidity, solvency, and equity Understand income statements and the ways to analyze them Know how to calculate financial efficiency ratios Understand and calculate profitability

Financial Ratios Take information from the financial statements and use it to provide an evaluation of several financial aspects of the business Divided into measures for ▫Liquidity ▫Solvency ▫Profitability ▫Financial Efficiency

Liquidity The ability of a business to generate enough cash to pay bills without disrupting business operations Determines the ability to meet short term debt and other obligations from available cash or other current assets Measures include: ▫Current Ratio ▫Working Capital ▫Debt Structure ▫Asset Structure Fig 1 p. 3-2

Current Ratio Current assets/current liabilities Measures the ability of the farm’s current assets if sold to cover the short-term liabilities Fig 1 p. 3-2 ▫The Kendall farm has a current ratio of 2.15:1 which indicates that for every $1 of current liabilities the farm has $2.15 of current assets.

Working Capital Current assets – Current Liabilities Reflects the actual dollars available after current assets are sold and current liabilities are paid Fig 1 p. 3-2 ▫Working capital for the Kendall Farm is estimated to be $202,972

Debt Structure Current liabilities/ Total liabilities Indication of the percent of total farm debt that is due in one year Fig 1 p. 2-3 ▫For the Kendall Farm in year 2, 21.44% of the total farm debt is due within the next 12 months If debt is continued to be paid off without incurring new, the debt structure percentage should increase A decrease in debt structure from one year to the next indicates that new term debt was incurred during the year

Asset Structure Current Assets/ Total Assets An indication of the percentage of total assets that will be used or sold in one year Fig 1 p.3-2 ▫For the Kendall Farm in year 2, the asset structure is 14.51% Not used frequently in business analysis An asset structure less than debt structure can be a symptom of farm liquidity problems ▫Should not be used as a stand alone measure of liquidity

Solvency Measures the ability of all assets if sold at market value to cover all debts. A business is solvent if total assets exceed total liabilities Also examines the relationships between debt capital, funds borrowed and invested in the business and equity capital (the owner’s funds invested in the business)

Measures of Solvency Net capital ratio Debt to asset ratio Equity to asset ratio Debt to equity ratio

Net Capital Ratio Total farm assets/ Total farm liabilities Shows the total dollar value of assets per dollar of total debt Influenced by the values placed on all farm assets Over-valuing assets leads to inflated estimates of net capital ratio Any net capital ratio less than 1 would indicate that total liabilities are greater than total assets and the farm business would be insolvent Higher net capital ratios are desirable Fig 2 p. 3-3

Debt to Asset Ratio Total Liabilities / Total Assets Measures what percent of the total assets of the farm business is owed to the creditors Useful in measuring the amount of risk in regard to debt against assets Fig 2 p. 3-3 ▫Debt to asset ratio for the Kendall farm decreased from year 1 to year 2 indicating that in year 2 the Kendall’s borrowed additional funds and total debt increased but that total assets values increased proportionally more

Equity to Asset Ratio Total Farm Equity/Total Farm Assets Measures the percent of total assets financed by owner’s equity capital An increase in the equity to asset ratio would indicate an increasing owner’s claim against the farm assets Fig 2 p. 3-3 ▫The Kendall’s equity to asset ratio for year 2 is 68.5%, indicating they own 68.5% of the farm’s assets free and clear of any debt. The ratio also increased from year 1 to year 2 indicating an increase in the Kendall’s claim against the business

Debt to Equity Ratio Total Farm Liabilities/Total Farm Equity Measures the relationship between debt financing and equity financing by the farm Often referred to as the leverage ratio since it reflects the way debt and equity are combined to finance the farm business Ratio equal to 1 indicates equal amounts of debt and equity financing Ratio less than 1 indicates more equity financing than debt and vise versa

Profitability Measures Show how efficient a business is in generating a profit from the use of land, labor management and capital resources Include ▫Net Farm Income from Operations ▫Net Farm Income ▫Return on Assets ▫Return on Equity ▫Cost of Debt ▫Operating Profit Margin Ratio

Net Farm Income from Operations (NFIFO) Total Revenue – Total Expenses, operating and fixed Considered to be the profit from the typical operation of the farm or ranch business Also represents a return to unpaid operator and family labor, equity capital and management Fig 3 p. 3-4, 3-5

Net Farm Income (NFI) Net Farm Income From Operations + Any Gain or Loss on the sale of capital items such as land and machinery Gain or loss on capital sales is not considered a part of the normal operations of the farm is not included. Instead it is added after the calculation of NFIFO

Return on Assets (ROA) Return to Assets ▫NFIFO + Interest (from income statement) – Opportunity Cost of Unpaid Operator and Family Labor Return on Assets ▫Return to Assets/ Average total assets Interest is added to NFIFO to give returns to unpaid operator and family labor, total capital and management By adding the interest that was subtracted in the income statement the result is an NFIFO as if there was no debt to the farm

Return on Assets (ROA)-Opportunity Cost For unpaid operator and family labor is subtracted to reflect a payment for the contribution of operator and family labor that is not shown as an expense on the income statement Should be an estimate of the value of the operator and family labor in their next best alternatives

Return on Equity Return to Equity/Average Total Equity Gives the rate of return on the owner’s equity

Cost of Debt (COD) Total Interest (from the income statement)/Average Total Liabilities (from Net worth statement) Should not be interpreted as an interest rate on a particular loan Simply gives interest as a percent of total farm debt Useful in estimating if debt capital is beneficial to the business

Cost of Debt & ROA & ROE* ROA > COD then ROE will be higher than ROA ROA< COD then ROE will be lower than ROA If the COD is less than the ROA causing ROE to be greater than ROA then the debt capital is beneficial to the farm business

Operating Profit Margin Ratio (OPMR) Operating Profit Margin ▫NFIFI + Interest – the opportunity cost of unpaid operator and family labor ▫Same calculation as the return to assets Operating Profit Margin Ratio ▫Operating Profit Margin/ Total Revenue (from income statement)

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) Net Farm Income from Operations + Interest Expenses, Depreciation expense and amortization expense Amortization expense refers to the proration of intangible assets ▫Similar to depreciation but applies to assets such as copyrights and patents A measure of profitability that examines the repayment capacity of the business Can be compared to upcoming principal and interest payments to reflect the adequacy to cover scheduled debt payments on term debt

Financial Efficiency Measures how effective the business is in generating revenue from the production and management decisions Measures ▫Asset Turnover Ratio ▫Operating Expense Ratio ▫Depreciation Expense Ratio ▫Interest Expense Ratio ▫Net Farm Income from Operations Ratio

Asset Turnover Ratio (ATR) Gross Revenue (from income ratio)/ Average Total Assets (from the net worth statement) Measures the operational efficiency by indicating the level of revenue generated per dollar of assets owned by the business

Operating Expense Ratio (OER) Total Operating Expenses – Depreciation/ Total Revenue Reflects the percent of total revenue devoted to operating expenses except depreciation Depreciation is treated as separate efficiency ratio

Depreciation Expense Ratio Total Depreciation Expense/Total Revenue Shows the percent of total revenue devoted to depreciation expense

Interest Expense Ratio Total Interest Expense / Total Revenue Percent of total revenue devoted to interest

Net Income from Operations Ratio Net Farm Income from Operations/Total Revenue Shows the percent of total revenue that remains for net income after all operating expenses and interest have been subtracted

Efficiency Ratio Wrap-Up Operating Expense Ratio, Depreciation Expense Ratio, Interest Expense Ratio and Net Farm Income Operations Ratio will always add up to 100% Each represents a portion of total expenses and net farm income is the percent of revenue remaining after all expenses

Summary* Financial ratios are a useful tool to measure the financial health of the farm or ranch business Ratios ▫provide trend analysis and comparative analysis ▫Assist in indentifying possible strengths and weaknesses in the financial condition of the business ▫Should be interpreted cautiously due to difficulties in the consistency of accounting data Ratio analysis is another tool in management of the business and can provide symptoms of financial problems