Chapter Eighteen

Farm Financial Analysis

Learning Objectives
• Upon successful completion of this chapter, participants will
be able to:
• Define the different classifications of ratios.
• Identify the calculations used for each of the farm analysis
ratios.
 Introduction
• Once the accounting information has been assembled into
financial statements, it can be reviewed to see how well a farm is
performing. This can be accomplished with horizontal analysis
and a number of ratios and other measurements, which are
discussed in the following sections.
 Horizontal Analysis
• One of the essential tools for reviewing the performance of a
farm is horizontal analysis. This is the comparison of
historical financial information over a series of reporting
periods, or of the ratios derived from this information.
• When conducting a horizontal analysis, it is useful to do so
for all of the financial statements at the same time, in order
to see the complete impact of operational results on the
farm’s financial condition over the review period.
• Horizontal analysis of the income statement is usually in a two-
year format such as the one shown next, with a variance also
reported that states the difference between the two years for each
line item.
• Horizontal analysis of the balance sheet is also usually in a two-year
format, such as the one shown next, with a variance stating the
difference between the two years for each line item.
• The easiest way to use horizontal analysis is to scan across each
line, looking for unusual dips in the numbers. Only investigate
material changes, which will probably only comprise a small
proportion of the total amount of presented numbers. By taking
this approach, the farm manager can pursue those issues that are
worthy of his time and avoid becoming bogged down in the
investigation of minor items in the financial statements.
 Financial Ratio Analysis
• A financial ratio is a comparison of two or more values taken from
a farm’s financial statements. These ratios can be used to compare
the condition of a farm from one year to the next, or to compare it
to the condition of other farms in the area. When tracked on a
trend line, these ratios can be quite effective in determining
patterns in the financial condition of a business.
• The main ratios that could be used to evaluate a farm are
performance ratios, efficiency ratios, liquidity ratios, and return
on investment ratios. They are described in the following sections.
 A. Performance Ratios
• Performance ratios are used to evaluate the information on a farm’s
income statement. They quantify the proportions of income being
generated by different aspects of a farm. These measures can also be
used to evaluate the quality of earnings and how closely a farm is
operating to its breakeven level.
 1-A Net Profit Ratio

• The net profit ratio is a comparison of after-tax profits to sales. It

reveals the remaining profits after all costs have been deducted
from sales and income taxes recognized. As such, it is one of the
best measures of the overall results of a farm. The measure is
commonly reported on a trend line, to judge performance over
time. It is also used to compare the results of a farm to those of its
competitors.
• To calculate the net profit ratio, divide net profits by net sales and
then multiply by 100. The formula is:
(Net profit ÷ Net sales) × 100
 Example
• Samar Farm has $100,000 of sales in its most recent month, and
production and other operating costs of $96,000.
• The income tax rate is 35%. The calculation of its net profit
percentage is: ?????????????????????
Answer
$100,000 Sales - $96,000 Expenses = $4,000 Income before tax
$4,000 Income before tax × (1 – 0.35) = $2,600 Profit after tax
($2,600 Profit after tax ÷ $100,000 Net Sales) × 100 = 2.6% Net profit
ratio
 2-A Operating Income Ratio
• The standard performance measurement for any business is the net
profit ratio, but that ratio suffers from the inclusion of one-time and
non-operating gains and losses. A way to discern the underlying level
of profitability is to use the operating income ratio, which compares
operating income to only those sales related to operations. To calculate
the operating income ratio, follow these steps:
1. Clean up the sales figure by eliminating any “sales” transactions that
are really interest income or one-time gains.
2. Clean up the net profit ratio by eliminating all financing-related
interest and income, as well as gains and losses on one-time
transactions. The result is operating income.
3. Divide the operating income figure by the adjusted sales figure.
 • The formulation of the operating income ratio is:

EXAMPLE
Dina Farms raised $100 million in a private stock placement two years ago, with the
intent of using the money to buy up a large amount of ranch land. The farm has
reported net profits of $4,500,000 and $5,200,000 in the following two years, but this
may be masking losses that are being netted against interest income on the $100 million
of cash. An investor quizzes the controller about this issue, and learns that $4,200,000
and $3,900,000 of interest income have been recorded as revenue in the past two years.
Total revenues reported were $62,000,000 and $67,000,000, respectively, in years 1 and
2. The following table eliminates the interest income to arrive at the company’s
operating income ratio:
The ratio reveals that most of the income reported by Dina farm has really
been derived from its investment of the $100 million of cash, rather than from
operations. However, the situation appears to be improving, since the operating
profit quadrupled in Year 2.
 3-A Breakeven Point
• The breakeven point is the sales volume at which a farm earns
exactly no money. It is useful for deciding how close to the edge of
failure a farm is operating, based on its current sales level.
• To calculate the breakeven point, divide total fixed expenses by the
contribution margin of the farm. Contribution margin is sales
minus all variable expenses, divided by sales. The formula is:

• A more refined approach is to eliminate all non-cash expenses

(such as depreciation) from the numerator, so that the calculation
focuses on the breakeven cash flow level.
 EXAMPLE
• A credit analyst is reviewing the financial statements of a farm that has
a large amount of fixed costs. The industry is highly cyclical, so the
analyst wants to know what a large downturn in sales will do to the
farm. The farm has total fixed expenses of $300,000, sales of
$800,000, and variable expenses of $400,000. Based on this
information, the farm’s contribution margin is 50%. The breakeven
calculation is:

= $600,000 Breakeven sales level. Thus, the farm’s sales can decline
by $200,000 from their current level before it will begin to lose
money.
 B- Efficiency Ratios
• Efficiency ratios are derived from the balance sheet, and are targeted
at the amount of assets that a farm is using in order to generate a
certain amount of sales. In the following sub-sections, we describe
efficiency ratios for assets in general and for working capital in
particular.
 1-B Asset Turnover Ratio

• The asset turnover ratio compares the revenues of a farm to its

average assets. The measure is used to estimate the efficiency with
which the farm manager uses assets to produce sales. A high
turnover level indicates that a farm uses a minimal amount of working
capital and fixed assets in its daily operations. To calculate the ratio,
divide sales by total average assets. The average assets figure is
derived by adding together the beginning and ending asset totals
for the measurement period and dividing by two. The formula is:
 EXAMPLE
Sunrise Farm has sales of $1,000,000, beginning total assets of $200,000
and ending total assets of $300,000. Its asset turnover ratio is:

In short, the farm is generating $4 of sales for every $1 of assets.

This ratio can be useful for comparing the results of different farms,
especially to see if any farms are operating outside of the median
turnover level for the group.
 2-B Working Capital Turnover
• The working capital turnover ratio measures how well a farm is
utilizing its working capital to support a given level of sales. Working
capital is current assets minus current liabilities. A high turnover
ratio indicates that the farm manager is being extremely efficient in
using short-term assets and liabilities to support sales. Conversely, a
low ratio indicates that a farm is investing in too many accounts
receivable and inventory assets to support its sales.
• To calculate the ratio, divide sales by working capital (which is
current assets minus current liabilities). The calculation is usually
made on an annual or trailing12-month basis, and uses the average
working capital during that period. The calculation is:
 EXAMPLE
• Woodbine Farm had $1,200,000 of sales over the past twelve months,
and average working capital during that period of $200,000. The
calculation of its working capital turnover ratio is:

• An extremely high working capital turnover ratio can indicate that a

farm does not have enough capital to support it sales; collapse of the
farm may occur soon. This is a particularly strong indicator when
the accounts payable component of working capital is very high,
since it indicates that the farm cannot pay its bills as they come due
for payment.
 C. Liquidity Ratios

• These ratios are used to discern whether a farm can meet its payable
and debt obligations as they become due for payment. These ratios are
particularly important for a farm, which may be operating under a
substantial debt load. We present three liquidity ratios in this section.
 1-C Current Ratio
• One of the first ratios that a lender or supplier reviews when
examining a farm is its current ratio. The current ratio measures the
short-term liquidity of a business; that is, it gives an indication of
the ability of a farm to pay its bills. A ratio of 2:1 is preferred, with a
lower proportion indicating a reduced ability to pay in a timely
manner. Since the ratio is current assets divided by current
liabilities, the ratio essentially implies that current assets can be
liquidated to pay for current liabilities.
• To calculate the current ratio, divide the total of all current assets by
the total of all current liabilities. The formula is:
 2.C Cash Ratio
• The cash ratio compares the most liquid assets to current liabilities,
to determine if a farm can meet its short-term obligations. It is the
most conservative of all the liquidity measurements, since it excludes
inventory and accounts receivable.
• To calculate the cash ratio, add together cash and cash equivalents
(highly liquid investments maturing in less than three months), and
divide by current liabilities. A variation that may be slightly more
accurate is to exclude accrued expenses from the current liabilities
in the denominator, since it may not be necessary to pay for these
items in the near term. The calculation is:
 EXAMPLE

• Missionary Ridge Ranch has $10,000 of cash and $40,000 of cash

equivalents on its balance sheet at the end of May. On that date,
its current liabilities are $100,000. Its cash ratio is:
 3-C Debt to Equity Ratio
• The debt-to-equity ratio of a farm is closely monitored by its lenders and creditors,
since the ratio can provide early warning that an organization is so overwhelmed by
debt that it is unable to meet its payment obligations. For example, the owners of a
farm may not want to contribute any more cash to the business, so they acquire
more debt to address a cash shortfall.
• Whatever the reason for debt usage, the outcome can be catastrophic if cash flows
are not sufficient to make ongoing debt payments. This is a concern to lenders,
whose loans may not be paid back. Suppliers are also concerned about the ratio for
the same reason. A lender can protect its interests by imposing collateral
requirements or restrictive covenants; suppliers usually offer credit with less
restrictive terms, and so can suffer more if a farm is unable to meet its payment
obligations to them.
• To calculate the debt-to-equity ratio, simply divide total debt by total equity. In this
calculation, the debt figure should also include all lease obligations. The formula is:
 EXAMPLE
• An analyst is reviewing the credit application of New Century Farm.
The farm reports a $500,000 line of credit, $1,700,000 in long-term
debt, and a $200,000 lease. The farm has $800,000 of equity. Based on
this information, New Century’s debt to equity ratio is:

• The debt to equity ratio is very high which the analyst is not allowed
to grant credit.
 D. Return on Investment Ratios
• Over the long term, the owners of a farm should have a keen interest
in the return being generated from the property. If the return is not
adequate, they may want to find an alternative use for their invested
funds. In this section, we cover the two most common measures of
the return on investment, which are the return on equity and the return
on assets.
 1.D Return on Equity

• The return on equity (ROE) ratio reveals the amount of return

earned by investors on their investments in a farm. It is one of the
metrics most closely watched by investors. ROE is essentially net
income divided by shareholders’ equity.
• ROE performance can be enhanced by focusing on improvements to
three underlying measurements, all of which roll up into ROE. These
sub-level measurements are: profit margin, asset turnover, and
Financial leverage
 2.D Return on Assets
• The return on assets measurement focuses on the amount and
usage level of the assets employed by a farm. To increase the
return on assets, there is a built-in incentive to either eliminate
nonproductive assets or increase asset usage. The formula is:
 Livestock Analysis Formulas
• The focus of this chapter has been on financial analysis, which
means examining the financial statements of a farm. In addition,
we include in the following table several formulas that may be of
use to those people managing livestock.
End of Chapter