Successful farm operators know the importance of continuously evaluating their business performance.
However, to do a thorough examination, farmers need to look at more than sales, profits and total assets. They must be able to read between the lines of their financial statements and make the seemingly inconsequential numbers more accessible and comprehensible.
This may seem overwhelming, but fortunately ratios are useful tools that can be used to analyze business performance.
Key measurements include current ratio, contribution margin ratio and debt servicing ratio.
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The good news is that ratios can be quantified with a high degree of confidence. They can be compared year over year to measure progress and are most meaningful when comparing the current year’s financial measures with the same measures from previous years.
The bad news is a ratio is only as good as the information that is used in its preparation. Because each ratio indicates something about the farm’s financial story, it’s important that they be analyzed collectively because some ratios can be counterintuitive.
Ratios can be grouped to provide more information on a farm’s performance, which I liken to reading three or four chapters of a book rather than reading the whole story.
There is no certainty in farming and the same can be said for using historical ratio analysis to draw conclusions on a farm’s future viability.
Having said that, grouping these three ratios, monitoring their year-over-year performance and making management adjustments to keep them within industry standards can provide valuable insight into a farm’s longer-term financial performance.
Current ratio
The current ratio is calculated by dividing the current assets by the current liabilities.
It provides an indication of the liquid assets available to meet the next 12 months of financial commitments, which are the current liabilities. It is closely associated with cash flow.
The optimum current ratio is 2:1 or better, which indicates that the farm would have $2 of current assets for every $1 of current liabilities. A current ratio of 1.5:1 and greater is considered to be strong.
Debt servicing ratio
The debt servicing ratio provides an indication of the ability of the farm to repay its term debt.
The calculation determines the amount of earned cash available for debt repayment for a year and divides it by the total interest and principal payments in that year.
A 2:1 ratio reveals that for every dollar of annual debt (principal and interest ) payments, the operation expects to have two earned dollars available. The ideal ratio may vary depending on the type of operation. A 1.5: 1 ratio and better is generally adequate for grain, mixed and cow-calf operations.
Contribution margin and contribution margin ratio
Producers can calculate their contribution margin by subtracting production expenses (fertilizer, seed, chemical, production insurance, feed, vet and medicine) and operating expenses (fuel, repairs, custom work and direct labour) from the gross accrued revenue.
They can then calculate the ratio by dividing the margin by gross revenue. The contribution margin ratio should be at least 50 percent.
The current ratio is associated with cash flow, which is crucial in today’s agriculture industry.
It also factors into current liabilities, which include annual term debt repayment commitments. An overly aggressive commitment to term debt repayment can negatively affect the current ratio and liquidity.
Debt servicing is related to net or earned income and looks at the farm’s earned ability to make debt payments.
The contribution margin also reveals how efficient a farm is at getting a return on the direct or variable costs that are incurred. Producers can improve the ratio by reducing costs or increasing yield and sale prices.
After accounting for the variable costs, producers must still address their fixed costs before dealing with net income.
However, poor performance at the contribution margin level almost always translates into less than desirable net income.
Few farmers are able to report satisfactory net income and a good debt servicing ratio when starting from a contribution margin that is consistently below 50 percent.
Farms will be better able to maintain longer-term viability if they keep a current ratio at 1.5:1 or better, a debt servicing ratio at 1.5:1 or better and a contribution margin at 50 percent or better.
The ratios are complementary, providing insight into different and related areas of financial performance and bridging the balance sheet and income statement.
Sub-performance in any one of the ratios will hurt the others and result in management challenges.
Terry Betker is a farm management consultant based in Winnipeg, Manitoba. He can be reached at 204.782.8200 or terry. betker@backswath.com.
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