I have the enjoyable privilege of driving my young granddaughter around Winnipeg, where she and I live. Like every youngster her age, she’s super observant and not shy in telling me what to do and where to turn to get to our destination.
She’ll tell me when she thinks I’ve gone the wrong way and remind me of my navigation mistakes. And then miraculously — to her I’m sure — when we arrive, she simply says “oh look, we’re here!”
She’s also very attentive when we’re approaching or stopped at a traffic signal and quick to remind me that red means stop and green means go. And she’s impatient if I don’t move right away when the light changes to green. She doesn’t know this, but she’s a lot like her mother was at that age, so the apple indeed doesn’t fall far from the tree!
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Many of you will have seen illustrations for farm businesses that express financial performance ratios as being red/amber/green. It’s the same format as a stop light but obviously used differently. I’ve used it in workshops and university classes I’ve taught, and with farm families to bring perspective to the significance of different ratios that present a picture of a farm’s financial situation.
At a traffic light, your options and the information presented are straightforward. If all motorists respected the rules, traffic would flow relatively smoothly. The risks increase when motorists don’t give enough respect to the amber or red signals.
What about for a farm? I think the same can be said for farms and the colours of their financial ratios. There certainly are risks associated with financial performance where the given ratio is in the amber or red zone. But are there risks associated with the green lights? I think so.
I’m often asked how I look at a farm’s financial performance. I will always look at these ratios, in this order:
- gross margin
- working capital percentage
- debt to equity
- debt servicing
- net operating profit margin
- operating efficiency margin
In general, they speak to efficiencies in operations, cash flow strengths or weaknesses, risks associated with debt and consideration to capital investment.
The tricky part about using ratios to analyze a farm’s financial performance — and much different from a traffic light, where there’s only one signal to heed — is that each ratio has its own red/amber/green signal.
The ratios collectively tell you something about your farm’s financial performance. You can have red, amber and green signals at the same time, albeit for different ratios.
Which ones to pay attention to, and when, is a key question. For many farmers, the answer “it depends” can be frustrating but it’s a fact. What ratios with what colours and when they should be heeded depends on what’s happening on the farm at any given time.
Is the farm expanding, transitioning, diversifying? Have there been consecutive years of adverse weather? Are there other factors affecting financial performance? Both good and bad? Financial performance does, in fact, depend.
A ratio with a red signal usually warrants attention to understand:
- Why the particular ratio is in the red zone.
- Its significance to a farm’s overall financial performance.
- What can be done about it, and when?
A green indicator for any given ratio is easier to understand. All systems go, in a sense. You’re stopped at a traffic signal and the light turns green, so you proceed. But how? Is it a full-throttle sort of thing or a more cautious start?
As I think about this, I don’t recall my granddaughter telling me what she thinks the amber traffic signal light is for. I guess for her it’s either stop or get going! For farms, given their financial realities, I wonder if a preferred approach to a green signal is to proceed, but at more of an amber speed.
If the green signal you’re looking at in the above ratios is the working capital percentage, that’s good because it indicates that your liquidity is strong. In these economic times, my advice is to be careful not to do something that will significantly weaken your working capital position. Carefully analyze the impact on your working capital percentage from an investment opportunity you may have. If making the investment will take your working capital percentage ratio into the amber zone, proceed cautiously. If one or more of the ratios are in the amber zones, be even more cautious.
The age-old saying that cash is king is more relevant than ever.
Terry Betker, PAg, is a farm management consultant based in Winnipeg. He can be reached at 204-782-8200 or terry.betker@backswath.com.
