GreenStone FCS | March 24, 2018
Steve Kluemper and Ian McGonigal
Financial benchmarks provide farmers key insights into how their operation is performing financially and help identify areas for improvement.
Benchmarks apply to every business operation. In order to run a successful operation, farmers need to understand their own financial position, and how their metrics relate to other, similar businesses.
While there are many financial ratios that deliver important information, there are three primary metrics every farmer should analyze: the Owner’s Equity Ratio, the Current Ratio, and the Debt Service Coverage Ratio, which measure solvency, liquidity, and debt repayment capacity, respectively.
The Owner’s Equity Ratio shows your net worth as a percentage of total assets, measuring your ability to withstand periods of financial stress. Net worth is calculated by subtracting the value of everything that is owed (total liabilities) from the value of everything that is owned (total assets).
The higher the ratio, the greater the solvency and the more total capital supplied by the owner and less by the creditors. The target is 50 percent-65 percent or higher.
The Current Ratio is a liquidity measure similar to Working Capital that shows the value of assets to be liquidated in the following 12 months (current assets) in relation to liabilities due in the following 12 months (current liabilities).
Working Capital is calculated as current assets less current liabilities and expressed as a dollar amount, where Current Ratio is a ratio of current assets divided by current liabilities.
They both indicate your ability to pay current liabilities from the normal liquidation of current assets rather than liquidating long-term assets or incurring more long-term debt.
The higher the Working Capital and Current Ratio, the greater the liquidity. The target for the Current Ratio is 1.25-1.75 or higher.
The Debt Coverage Ratio determines your debt repayment capacity. It is calculated as a ratio of your annual earnings after all expenses, including owner withdrawals and family living expenses, except for interest and depreciation expenses, divided by your annual principal and interest payments.
The greater your earnings are to cover debt payments, the easier you can handle planned and unplanned capital spending as well as changes in revenues and expenses.
A debt-coverage ratio less than 1.00 means there were insufficient earnings to repay all debt payments and working capital was used to make the payments. The Debt Coverage Ratio target is 1.15-1.50 or higher.
These benchmark target ratios are based on general financial management best-practices, as well as on GreenStone’s extensive analysis of the financial performance of our customer-owners.
Whenever you compare your operation to a benchmark number, you should always ask how the benchmark was derived, how many operations and how many data points were included in the analysis, and how similar they are to your operation.
In addition to letting a farmer understand how his operation is performing financially, financial metrics and ratios are also used to make lending decisions, though they are not the only factor.
For example, GreenStone Farm Credit Services loan professionals review our customers’ business plans carefully, assess their management strengths and weaknesses, and have in-depth conversations to explore their business opportunities and challenges, rather than relying solely on a few financial measurements.
The financial position of any operation evolves over time and the financial ratios will also ebb and flow. An operation that is expanding to take advantage of an opportunity may leverage a significant portion of its resources, which will weaken some financial ratios.
An experienced lender understands this as a temporary situation where, as the expansion plays out, the financial ratios should improve. They also understand that if one financial ratio is outside the target range, other ratios and credit factors may be strong enough to approve a sound, constructive loan.
Farmers should develop the discipline to calculate their financial ratios and compare them to industry benchmarks in line with their production schedule: annually for crops and at least quarterly for livestock.
While industry groups and accountancy firms often offer their own benchmarks, GreenStone has developed an extensive database of financial ratios representing a diverse customer base, and can tell individual producers how they are doing compared to the rest of the portfolio.
To provide meaningful information, GreenStone common-sizes the data to compare the balance sheet, earnings, and cost of production information per unit of resource such as acres, cows, etc. and per unit of production such as bushels, pounds, etc.
The common-sized metrics will have variability based on the solvency, liquidity, earnings and debt repayment rates of each operation in addition to differences in business practices such as the amount of assets rented and owned, the amount of inputs produced and purchased, etc. Financial services officers can assist producers in comparing financial metrics to similar operations.
Benchmarks are a valuable tool farmers can use to help improve their operation and make informed, strategic decisions.
As with any tool, the value is in how the information is put to use, recognizing that benchmarks are only a target to aim for. If a ratio is outside the optimal benchmark range, there is no need to panic, especially for young and beginning farmers.
Rebalancing your debt obligations with your lender is often a solution to improve ratios outside of the optimal range.
Understanding the financial implications of operational decisions takes time. Applying a consistent approach to analyzing your financial ratios and making decisions accordingly can work over time to improve your financial position.
Kluemper is Vice President of Credit and McGonigal is Senior Vice President of Regional Sales at GreenStone Farm Credit Services.