If we follow the soil test analogy of understanding the farm’s financial health, how do you go about actually testing your farm’s financial health to make more informed and effective decisions?
Like a soil test, we have to collect our core samples from which we will analyze our farm’s financial condition. The core samples of “financial sampling” your farm are found in three important documents: a balance sheet; an income statement; and cash-flow statement.
The balance sheet is a snapshot in time of a business’ assets, liabilities, and net worth (i.e. owner equity). It tells us whether the farm’s cash flow is enough to cover debts within the normal course of the year or if the farm were forced to liquidate; giving us a snapshot of what our financial situation is at the moment. It focuses on two main concepts; liquidity and solvency.
Liquidity is the ability of your farm operation to meet financial obligations as they come due, by looking at three ratios: current ratio, working capital, and working capital to gross incomes. These ratios can be found in detail under the Farm Financial Ratio series by Adam Kantrovich on the MSU News webpage.
In thinking about liquidity, let’s go back to our soil test example. This would be similar to knowing if we had enough available nutrients to meet the plant’s needs and reach our yield goal. Do we have enough? Do we need to add more? How should we begin planning to add them?
Solvency is the ability of your farm to pay all of its debts as if it were sold tomorrow. This is important in evaluating the financial risk and borrowing ability of the business. The ratios it focuses on are debt-to-asset, equity-to-asset, and debt-to-equity.
What would solvency be on a soil test? The pH levels tell us what nutrients are free or unbound by the soil and available for the plant to use.
How many of our assets are tied up by debt? Do we have more to borrow against? If we had to sell today, could we pay off all our debts?
The next important document is the income statement. It measures profitability and how the business got to its current financial situation over a period of time.
Profitability is the difference between the value of goods produced and the cost of the materials used to make them. This could be used to cover family living, taxes, or reinvested into the business, which increases your farm’s net worth.
It focuses on a number of different ratios, including net farm income, rate of return on assets, rate of return on equity, operating profit margin, and earnings before interest, taxes, depreciation, and amortization (EBITDA). Each of these measure the farm’s profit that is returned from investments in capital, land, labor, and even management.
How would we think about profitability with a soil test? Did we reach our goal with what we put toward it? What did we get back for our efforts in the growing season? After we’ve paid for everything, is there anything left over that could be used for other things or even used next year?
Take a moment to compile and review your farm’s latest balance sheet and income statement.
- Where is its financial health related to liquidity, solvency, and profitability?
- Are the assets you have on-hand enough to pay the bills due at the end of the year?
- How many of these assets are truly free for the farm to use?
- What money was left over to put toward other investments the farm wants to make?
This is the second of a four-part series on farm financial health.
The first part of this four-part series can be found here.
In the next part of this series, we’ll talk about the cash flow statement and how all three financial documents function together to help you understand as well as make use of your farm’s financial health