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Business management tools to keep you on track

01/09/2005


Analyzing a business is clearly not restricted to the use of ratios. However, ratios are indeed very useful tools that can be used when analyzing the performance of a business.

Ratios are most meaningful when comparing the current year’s financial measures with the same measures from earlier years. I t is yet even more meaningful when the ratio can provide comparative results to industry standards and to peer farmer performance.

It should be noted that there are limitations in using ratios. Proper analysis of a business requires more than just ratio analysis. Limitations such as the basis for asset valuation, business type/sector, business size and cycle should be kept in mind.

Categorization of Ratios

Financial ratios can be separated into four categories: Liquidity, Solvency, Financial Efficiency, and Profitability. For the purposes of this article, I will discuss Liquidity and Financial Efficiency. These indicators are most closely related to things that happen in your business that in turn can quickly impact on cash and cash flow management.

Liquidity: The ability of a business to meet financial obligations as they come due in the ordinary course of business. These indicators are related to cash and shorter-term risk.

Financial Efficiency: The extent to which a business is able to utilize its resources efficiently. Resources here refer to management inputs, both variable and fixed.

LIQUIDITY

Current Ratio & Working Capital

The current ratio is calculated by dividing the current assets of your business (such as inventory and accounts receivable) by the current liabilities (such as operating loan, accounts payable, advance payments and term debt principal repayment due in the year).

Working capital is calculated by subtracting the current liabilities from the current assets. The result is the net dollar surplus (deficiency) of current assets available to meet the obligations of the business over the upcoming year. A deficiency in working capital is referred to as negative working capital. Negative, or even less-than-adequate working capital usually results in lender issues and how farm management decisions are made. Decisions related to marketing of commodities and the day-to-day operation of the business.

The farm’s working capital is an indication of money available for operating costs for the following year. The current ratio provides an indication of the liquid assets available to meet the next twelve months of financial commitments (the current liabilities).

The optimum current ratio is a ratio of 2:1, or better, which indicates that the farm would have $2.00 of current assets for every $1.00 of current liabilities. A current ratio of 1.5:1 and greater is considered to be a strong current ratio. A current ratio of 1.2:1 - 1.5:1 is considered to be marginal. A negative current ratio is a strong indication of concern. Current ratios can change significantly with each production year.

When analyzing the relationship between current assets and current liabilities, it is important to note the dollar value of the working capital. That is, current ratio may indicate a ratio of 1.3:1, yet working capital may not be adequate because the dollar values of current assets and current liabilities may be relatively small. In other words, a 1.3:1 current ratio may have working capital of $20,000 or $200,000.

Rule of thumb indicator: 2 – 1

A higher number indicates better performance.

Working Capital As A Percentage Of Expenses

Working capital as a percentage of expenses is calculated by dividing the available working capital by the year’s cash expenses (expenses not including amortization or depreciation). As indicated above, working capital provides an indication of liquidity in ‘real’ terms or dollars, not just a ratio. This is a valuable measure, but further analysis is required. A farmer could have significant working capital, but what working capital is required for the next year? Working capital expressed as a percentage of expenses quantify the indicator as it relates to the size of the operation (i.e., a larger operation requires more working capital).

Rule of thumb indicator: > 25% of next year’s requirements.

A higher percentage indicates better performance.

FINANCIAL EFFICIENCY

Contribution Ratio

The contribution ratio is calculated by dividing the contribution margin by gross income. The contribution margin is calculated by subtracting crop variable inputs (such as seed, chemical, fertilizer, fuel and repairs) from gross income. While profitability is a function of many things on a farm, optimum efficiency realized from investment in inputs is of primary importance.

All producers make decisions relative to the amount of investment in variable costs. Generally, for every dollar invested in these inputs, there should be at least two dollars of revenue from production.

The following graph illustrates a trend in the efficiency of a farming operation. Trend line analysis is extremely important tool when analyzing the performance of a business and it applies to all indicators.

Production in farming can be highly variable and as a result, the contribution margin ratio can move up and down from year to year, depending on yield and price. Trend line performance, as illustrated, should be ‘red flagged’ and analyzed to determine what has happened and why. Particularly worrisome is a situation where an expanding farm (i.e., increasing acreage) is reporting a declining contribution margin ratio.

I cannot stress strongly enough the importance of calculating and analyzing the efficiency within a farm business, as expressed by the contribution margin ratio!

Rule of thumb indicator: > 50%

A higher percentage indicates better performance.

Net Operating Profit Ratio

The net operating profit ratio is calculated by dividing the net operating profit margin by gross revenue. The net operating profit margin is calculated by subtracting variable and fixed costs (such as property taxes, utilities, professional fees, amortization and interest) from gross revenue.

A farm manager’s first area of analysis relative to profit is to determine what contribution to profit is coming from the utilization of variable inputs. The second area is to determine what profit remains after paying fixed costs. It is possible to have farms that generate sustained and excellent margins over variable costs, but report unacceptable net profit. In these situations, it is likely that fixed costs, as measured on a per-unit of production basis, are too high.

Farm managers must either reduce the fixed costs, or increase the productive asset base and therefore reduce the fixed costs per unit of production. Either tactic, or a combination of both tactics, should be explored as ways in which to increase profitability.

Rule of thumb indicator: > 20%

A higher percentage indicates better performance.

By Terry Betker, Director, Agriculture - Industry & Government. For more information on this topic, contact your local MNP advisor or Terry at 204.788.6055.