AGRICULTURE

The Hidden Stories of Financial Statements

Financial statements…… per pound they have got to be the most expensive commodity around. They are demanded by my banker, the equipment finance companies, government, and just about anyone else who thinks they should know what goes on in my farm. Why do all these people want to see my financial statements? What could they possibly learn about my farm business by looking at a few pieces of paper?”

At first glance financial statements appear to tell you only very basic information: revenue, expenses, profit, assets, liabilities and equity. Not much of a story considering all that goes on in a farming operation. But move those numbers around some; add, subtract, multiply and divide, look at the trends, and the plot suddenly thickens. The story told by financial statements is very revealing to those who know their secrets.

A financial statement story is not an adventure, nor is it a romance. It may perhaps be a self help storey, as long as it is not fiction. While some stories told are exposes, others are testimonials. Part biography, part history, sometimes fantasy, a financial statement tells far more than just the words and numbers on the page. But whatever the story may be, it is best read as a series. A knowledgeable story reader will compare financial statements for five or more years to get the true message of the author. The meaning of the story is further enhanced by comparing it to other similar stories.

In many well written stories the reader must read between the lines to get the real meaning. In the case of financial statements the reader must actually move the numbers and calculate mathematical relationships to unearth the true story. To read between the financial statement lines the reader uses Ratio Analysis.

Ratio Analysis is an analytical tool used to assess and monitor a farm's health in terms of liquidity, coverage, profitability and financial efficiency. It draws the reader to areas that may require attention, and can show trends that will impact the future direction of the farm. Can we get to where we are going? Are there problems with our financial situation? Do we need to make some changes?

Financial ratios are divided into four basic categories:

Liquidity - a measure of a farm's ability to meet its current financial obligations as they come due. Liquidity is an indicator of a farm's cash flow health and short term risk profile.
Coverage - a measure of a farm's debt relative to the investment by the owners (equity) and the impact of that debt on the operations. Coverage ratios indicate a farm's long term risk profile.
Profitability - a measure of a farm's ability to generate profit from its assets. It is a measurement of management's ability to generate a return.
Financial efficiency - a measure of the efficiency with
which a farm utilizes its inputs to produce profit.

Here are a few of the more common ratios applied by creditors and analysts to agricultural enterprises.

Liquidity Ratios
Does a farm have sufficient cash, accounts receivable and inventory to cover its bank overdraft, accounts payable and taxes payable? Good liquidity tells suppliers a farm can pay their accounts on time. Good liquidity helps farmers negotiate good credit terms. Poor liquidity may mean C.O.D. with suppliers and higher interest rates and fees from the bank.

Working capital = current assets minus current liabilities
Desired result: Positive number
Desired trend: Increasing

Current ratio = current assets divided by current liabilities
Desired result: 2.0
Desired trend: Increasing

Debt structure ratio = current liabilities divided by total liabilities
Desired result: 20%
Desired trend: Decreasing

Coverage Ratios
Coverage ratios measure the impact of debt on a farm by showing the relative use of borrowed funds as compared to the investment of the owners. Too much long term debt increases the risk to creditors through high interest charges and insufficient security. Unsatisfactory coverage ratios often result in high interest rates, unfavourable lending terms or even the denial of credit.

Debt to equity = total debt divided by total owners' equity
Desired result: .4 to 1
Desired trend: Decreasing

Debt servicing ratio = Income before interest and amortization divided by interest and principal payments
Desired result: 2 to 1
Desired trend: Increasing

Profitability Ratios
Profitability ratios are “return on” ratios which measure profit against other financial statement items such as owners' equity, revenue and total assets. Profitability ratios assess how well management has employed the farm's assets to generate a profit. These ratios are best evaluated by comparison to other farms in the same industry.

Return on equity = Net farm income divided by equity
Desired result: 10%
Desired trend: Increasing
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Return on assets = Net farm income minus interest expense divided by total assets
Desired result: 4%
Desired trend: Increasing

Capital turnover = Gross farm revenue divided by capital assets
Desired result: 40%
Desired trend: Increasing

Financial Efficiency Ratios
Financial efficiency ratios evaluate how effectively management has applied the inputs of the farm to produce a profit.

Gross margin = Gross revenue minus direct expenses divided by gross revenue
Desired result: 50%
Desired trend: Increasing

Return on revenue = Net farm income divided by gross revenue
Desired result: 20%
Desired trend: Increasing

Ratio analysis is a valuable tool for understanding a farm's financial statements. It measures relationships between financial statement items and compares the results with those of prior years. Ratios can be compared with other farms and industry averages. Ration analysis also provides a benchmark from which to measure future performance and set future goals. Ratios are most effective when they are used to highlight trends over several years. The absolute number is not as important as the direction of the trend.

Ratio analysis certainly makes for interesting reading. The story between the financial statement lines can make an otherwise dull book suddenly become a best seller. 

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