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Long-Term Trend Analysis

Amanda Blocker, Gregg Ibendahl, and John Anderson

Introduction have tapped all their credit may be facing a cash-flow


Long-term trend analysis is critical for helping a cotton problem even if their current ratio is fine.
farmer thrive. Using ratios to analyze a cotton farm is
always a good management practice. Using farm ratios Because farm credit is so important, it is probably
to benchmark a farm in a given year can be helpful in more beneficial to monitor short-term use of credit
spotting current problems. However, to spot problems rather than over-analyzing the current ratio. This is
that may occur in the future, long-term trend analysis definitely an area that should not be increasing over
is needed. Long-term trend analysis can also show time. Credit-card use falls into this area as well. Often,
bright spots in the business and can help with asset farms will hide problems by taking on more short-term
allocation. credit. A careful analysis of short-term loans can keep
this from happening. Certainly, a bad year can cause
Trend analysis is nothing more than taking historical short-term borrowing to increase, it just should not be
farm financial ratios and analyzing the trends. Because a multiyear trend.
weather and other factors can affect net farm income
in a given year, a one-year snapshot of farm financial Solvency
information can be misleading. Thus, a multiyear Solvency is the most important area for trend analysis
analysis of farm ratios will give a better picture of farm as it gives the best indication of long-term viability.
finances and whether the business is thriving. The debt-to-asset ratio is likely to start high but should
decline over time. This is especially true if the farm is
Most cotton farms fit into a basic model of high initial not expanding. However, farm expansion could cause
debt which declines over time. Beginning farmers often exceptions to this rule as new land purchases will add
have little equity and will typically borrow all they debt to a farm’s balance sheet. These expansions will
can to help purchase land and other assets. This is true cause a rise in the debt-to-asset ratio in the year of land
even for family farms as a new generation often must purchase. However, in subsequent years, the debt-to-
purchase land from mom and dad. As farmers mature, asset ratio should start trending down again.
they will buildup equity and decrease their percentage
use of debt. This model of farm use of debt has differ- The debt-to-asset ratio should always be calculated
ent implications for the five categories of farm ratios. with book value numbers from the balance sheet so that
inflation of land values does not mask debt problems.
Liquidity A long-term decrease in farm equity is a problem to
Liquidity shows the ability to meet current obligations. the on-going viability of the farm operation and needs
Normally the current ratio is best for long-term trend to be remedied quickly.
analysis. The current ratio should always be greater
than one and probably closer to two or more. This ra- Profitability
tio should be around two even for beginning farmers. Profitability ratios, ROA and ROE (Return On Assets
and Return On Equity), should be improving over time.
An important area to watch with liquidity is availability Weather and other problems can affect these ratios in
and use of farm credit, particularly short-term credit. any given year. However, long-term trends should show
Revolving credit lines are not included in the ratio improvements or at least a steady state. Certainly, both
calculation. This credit can provide plenty of funds as of these ratios should be positive.
long as the credit is unused. However, farmers who
An important area to analyze is the relationship be-

The authors are respectively, Graduate Research Assistant, Assistant Extension Professor, and As-
sociate Extension Professor in the Department of Agricultural Economics, Mississippi State University.
tween ROA and ROE. ROE should always be greater relationship between these two ratios. New equip-
than ROA. This indicates that debt capital is earning ment, indicated by a higher depreciation expense ratio,
more than the interest cost on the debt. When ROA is should have lower operating expenses. By contrast
greater than ROE, then debt capital is earning a rate older equipment, indicated by a lower depreciation
of return less than the interest rate on that debt. This expense ratio, should have higher operating expenses.
second situation is very bad for farm viability. If debt Where cotton farmers need to watch out is when both
capital cannot pay its own way, then assets are not be- operating expenses and depreciation expenses are high.
ing used effectively or debt capital should not be used This might indicate something about the maintenance
in the operation. As mentioned above, ROA might be program on the farm.
greater than ROA in a given year due to bad weather,
etc. However, the trend should be to have ROE greater Conclusion
than ROA. Table 1, which comes directly from Financial Guide-
lines for Agricultural Producers, summarizes all the
Financial Efficiency limitations of the 16 farm financial ratios. While most
These ratios should also improve over time. The ef- of the ratios have some limitations, they can provide
ficiency ratio showing the most improvement should valuable help in identifying problem area. The ratios
be the interest expense ratio. This ratio shows the drag do not show specific problems or what should be done,
debt is applying to farm produced revenue. Anything but they do show areas that should be examined more
over 10% means most farmers will have trouble com- closely.
ing up with funds to pay expenses and provide family
living expenses. This ratio should improve as debt is Ratios can be useful for a one year comparison of simi-
paid down. lar farms and also in a multi-year trend analysis when
examining a farm over time. It is critical though to start
Some of the other efficiency ratios go hand-in-hand off with an accurate set of farm financial statements.
together. Operating profit margin and asset turnover Ratios prepared from inaccurate financial statements
ratio, when multiplied together, give ROA. Thus asset will be inaccurate as well.
profitability is really about two things: what kind of
margin is earned on every dollar sold and how effec- As long as care is used in preparation, then farm fi-
tively are farm assets being used. Improving operating nancial ratios can be a valuable analysis tool. Care just
profit margin is often difficult for most farms as many has to be used in interpretation and any comparisons
of the factors affecting this ratio are outside the farm’s to other farms should be based on similar farm size,
control. Yields, prices, and operating expenses are three type, and age of operator.
major items that go into determining operating profit
margin. Asset turnover ratio, by contrast, is more con-
trollable by farmers. A frequent problem, especially as
farmers age, is acquiring too many assets for a given
farm base. Remember, if an asset is sitting in a shed, it
is not earning money. Thus a farm can improve asset
turnover, and by extension, farm profitability simply
by using assets more fully.

Having extra farm assets does provide more flexibility


in getting a crop out in a timely manner and by having
some insurance should something break. However,
extra equipment must always be weighed against the
drag this will put on ROA.

The other two ratios that go together are operating


expense ratio and deprecation expense ratio. The
operating expense ratio reflects the cost to maintain
and operate equipment. Depreciation expense reflects
something about the age of the equipment. Therefore,
it seems logical to expect something of an inverse
Table 1. Limitations of the Farm Financial Ratios*
Liquidity
Current liabilities should include the current portion of deferred taxes, otherwise
current ratio and working capital may be overstated.

These measures only show a "static" picture of the financial situation at a certain
point of time. These measures do not take into account future cash flows that could aid
in meeting debt obligations.

Working capital is a dollar amount measurement, making it difficult to compare to other


farms' numbers, because different farms have different cash flows.

Current ratio does not take into consideration line of credit that could be used to pay for debt.

Working capital does not take into consideration lines of credit that could be used to pay
for inputs and/or inventories.

The ratios do not consider that all liabilities are not due at that moment in time, or that
some current assets can't be converted to cash almost instantly.

The value of current ratio and working capital is affected by the valuation of current assets

Some current assets may not be sold for the amount listed on the balance sheet. Quality
of an asset plays a large part of any asset's true value and is not taken into account in
the calculation of current ratio or working capital.

Current ratio's and working capital's desirable level can vary across different types of
operations. Some farms receive monthly incomes (i.e. dairy farms), where others receive
seasonal incomes (i.e. beef, poultry, vegetable farms)

Different stages of the production cycle can affect the value of current ratio. A farm in the
planting stage is liable to have more liabilities due to purchasing inputs than a farm at
the harvesting stage whose assets have increased due to grains in storage or that have
been sold.

Solvency
Failure to include deferred taxes can understate debt/asset ratio and debt/ equity ratio. It
can also cause the equity/asset ratio to be overstated.

The ratios are affected by the valuation of farm assets. Using current market value without
considering deferred or estimated taxes can make the asset seem more valuable than it
is. Book value does not usually give an accurate value for an asset. If the business is
still an on-going business, liquidation value may not be the best measure of value of an asset.

There is no single best value for these ratios. Different types of operations will have
different ratio values and ranges. Things such as income, risk, land ownership, and asset
values can fluctuate the acceptable range of values these ratios can take.

* Note: Table 1 is taken directly from Financial Guidelines for Agricultural Producers, December 1997. This document is
available from http://www.ffsc.org/
Table 1. Limitations of the Farm Financial Ratios (cont.)
Profitability
These ratios are calculated using net farm income from operations, and net farm income
from operations is calculated before taxes; therefore, taxes should be considered when
analyzing these ratios.

Withdrawals for unpaid labor and management must be stated correctly otherwise ROA,
ROE, and operating profit margin ratio can be overstated or understated.

ROA and ROE may appear lower in value than a non-farm investment like stocks and bonds;
however , keep in mind that realized and unrealized capital gains on farm real estate
and other assets have not been taken into account.

ROA and ROE are affected by the valuation method used to value assets.

Calculations for ROA and ROE should not include assets and income not related to the
farm business, otherwise the value of ROA and ROE will be distorted.

ROA and ROE varies with different farm types. Land ownership, and ownership of some
assets can affect these ratios.

ROE can be understated if the deferred taxes are not included in liabilities.

ROE should be analyzed carefully. While most consider a high ROE good, it can
be an indicator of a highly leveraged, or undercapitalized farm. A low ratio can indicate
a more conservative farm with high equity. Since this ratio is difficult to evaluate alone,
it should be considered along with other ratios.

Operating profit merging ratio can be overstated or understated if revenues and expenses
are not used to help measure net farm income from operations.

Net farm income is measured in dollars; therefore, making it difficult to compare against
other farms as this value can be positive or negative, and may vary throughout the year.
Also different farms have different cash flows which will affect this value.

When comparing net farm income to another farm's, the ways of accounting must be
considered. Different farms have different ways of accounting. If the comparable farm has
a different accounting method, adjustments must be made to accommodate those differences.

Net farm income matches revenues with the expenses that were incurred in creating
those revenues. If the farm uses cash basis accounting on its income sheets, both the beginning
and ending balance sheets that have been accrual adjusted are needed to adjust changes
in inventory, accounts payable and receivable, and prepaid and accrued expenses.

Financial Efficiency
Asset turnover ratio is affected heavily by the valuation of assets.

When calculating average total farm assets in the asset turnover ratio, assets that are
not related to the farm should not be included.

Land ownership and type of farm can greatly vary asset turnover ratio.

When calculating asset turnover ratio, keep in mind that gross revenues reflect an entire
accounting period, while average total farm assets only consider two points in time during
that accounting period.

Operating ratios(operating expense ratio, depreciation/amortization ratio, interest expense


ratio, and net farm income from operations ratio) are affected greatly by the accuracy
of the values used in the calculations.

Operating ratios do not take into account taxes because net farm income is calculated
before taxes are taken out.

Depreciation/amortization ratio is greatly affected by farm type and the accounting


method used in depreciation/amortization.