Financial Ratios

Know Your Numbers, Know Your Options Author

06/18/2020 Added

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By Austin Duerfeldt

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[00:00:00.229](upbeat music)
[00:00:09.290]Now that we've talked about the balance sheet,
[00:00:11.230]there are some benchmarking ratios that we can use
[00:00:13.700]to monitor internal progress year versus year
[00:00:17.780]and external comparison our farm versus comparable farms.
[00:00:22.650]The ratios that are associated with the balance sheet
[00:00:25.620]are considered liquidity, solvency and coverage ratios.
[00:00:30.050]These ratios are tools to help identify
[00:00:33.090]our strengths or areas of improvement.
[00:00:37.460]Consider the following concept of running
[00:00:39.320]a firewood business.
[00:00:41.200]Each day people arrive at your door and place orders
[00:00:43.610]with money to receive firewood from you.
[00:00:46.800]What do you think the confidence level
[00:00:48.770]of those people would be if they saw the tool you were using
[00:00:51.410]to make the firewood was a butter knife?
[00:00:55.670]With a tool of that size and caliber,
[00:00:57.700]one would be lucky to receive any firewood at all,
[00:01:00.180]at the end of the day.
[00:01:02.190]What if instead of a butter knife,
[00:01:04.490]what they saw was a skid steer mounted circular saw?
[00:01:09.070]While the firewood created should be plentiful,
[00:01:11.000]the output capacity is oversized
[00:01:13.650]and costly to maintain for the market.
[00:01:16.940]Finally what if you saw that the tool being used
[00:01:21.370]was but a humble long handled tax?
[00:01:24.680]Easy to maintain yet productive,
[00:01:27.240]it should convey confidence that the job will be completed.
[00:01:30.840]Just like with this woodcutting business
[00:01:33.590]financial ratios are tools that provide an outlook.
[00:01:37.250]Bankers and owners of farming ranches can use
[00:01:40.020]financial ratios to gauge the confidence in the business.
[00:01:44.750]It might be that due to too little farm assets,
[00:01:48.170]or loss of liabilities, the outlook of repaying
[00:01:51.060]additional loans is worrisome to lenders.
[00:01:54.220]You could also find that a ratio is extremely strong
[00:01:59.230]and holding back profitability
[00:02:01.270]due to a lack of proper investing in the business's growth.
[00:02:05.520]Let's go through the four ratios mentioned
[00:02:07.970]and talk about what they are,
[00:02:10.850]how they are calculated,
[00:02:12.650]and some limitations.
[00:02:15.170]The first ratio we'll talk about is net worth.
[00:02:18.690]Net worth is calculated by taking assets
[00:02:21.250]and subtracting liabilities.
[00:02:23.950]Net worth is often considered one of the most
[00:02:26.040]accurate measures of wealth.
[00:02:28.360]That is if all of your bills are paid, what is left?
[00:02:32.670]This singular calculation is the greatest tracking measure
[00:02:35.450]for financial progress.
[00:02:37.630]Often people will brag about income
[00:02:40.260]as a focal point for success.
[00:02:43.320]The problem with income
[00:02:44.970]is it lacks the consideration for the expenses,
[00:02:48.550]taxes and other items it took to generate that income.
[00:02:53.750]Net Worth also levels out the perception of assets values.
[00:02:59.560]While I may have $3,000,000 worth of land assets,
[00:03:03.260]I may have $900,000 in debt.
[00:03:06.660]It can be viewed the other direction as well.
[00:03:10.530]I may have $900,000 in debt,
[00:03:13.600]but have total assets of $3,000,000.
[00:03:16.820]Viewing the debt alone appears astronomical.
[00:03:20.420]But when tied to the asset value,
[00:03:22.570]the level is not as extreme as it appears.
[00:03:26.380]The next ratio we'll look at is working capital.
[00:03:29.540]To calculate working capital, what we need to do
[00:03:31.560]is take total current farm assets
[00:03:34.510]and subtract out the total current farm liabilities.
[00:03:39.270]Working capital is a theoretical measure
[00:03:42.040]of the amount of funds available to purchase inputs
[00:03:44.570]and inventory items.
[00:03:46.130]After the sale of current farm assets
[00:03:48.700]and the payment of all current farm liabilities.
[00:03:52.520]The amount of working capital considered adequate
[00:03:56.020]must be related to the size of the farm operation.
[00:04:00.190]With that said, here are a few key points
[00:04:03.600]of limitations when looking at this ratio.
[00:04:08.930]First off, the current portion of deferred taxes
[00:04:12.540]should be included as current liabilities.
[00:04:15.470]Failure to do this may overstate working capital.
[00:04:20.090]Secondly the measure is a $1 amount.
[00:04:24.440]So it's difficult to compare the measure across
[00:04:26.830]farm businesses it's important to establish
[00:04:29.710]one standard for all farm businesses.
[00:04:33.880]The third point the measure is a static or stock concept,
[00:04:38.950]of the financial resources available at a given point
[00:04:41.740]in time to meet the obligations at that time.
[00:04:45.670]It does not measure or predict the timing
[00:04:48.010]of future fund flows.
[00:04:50.040]Nor does it measure the adequacy of future fund inflows
[00:04:54.230]in relation to the outflows.
[00:04:57.980]A fourth concept to remember.
[00:05:00.920]The measure ignores committed lines of credit as financial
[00:05:05.750]resources available to purchase inputs and inventories.
[00:05:11.390]The next one.
[00:05:12.420]The measure does not recognize that many current farm assets
[00:05:16.680]cannot be liquidated instantly.
[00:05:19.450]But at the same time, many current farm liabilities
[00:05:23.040]are not due instantly.
[00:05:25.340]By convention, both current farm assets and current farm
[00:05:29.680]liabilities are based on a one year time horizon.
[00:05:35.630]Next the value of the measure will be affected
[00:05:39.200]by the value placed on current farm assets.
[00:05:45.000]The next one is there is no indication
[00:05:48.340]of the quality of the current farm assets
[00:05:51.760]or whether those assets can be sold
[00:05:53.840]for the amount shown on the balance sheet.
[00:05:57.290]And the last limitation that you need to keep in mind.
[00:06:00.800]The desired level for the measure will vary
[00:06:03.800]by the type of business enterprise,
[00:06:07.230]ie an example a dairy with a monthly income,
[00:06:11.510]a fruit and vegetable farm with inventory levels
[00:06:14.010]that vary by season.
[00:06:15.930]And with term debt obligations,
[00:06:18.690]a cash grain operation that sells at harvest,
[00:06:22.540]or store for later sale,
[00:06:24.900]will all have different measuring indications.
[00:06:31.360]So that gives you an idea of working capital,
[00:06:34.920]how it's calculated,
[00:06:36.227]and some things you need to keep in mind
[00:06:38.680]when you're analyzing and looking at your numbers
[00:06:42.590]as to what it actually means for you.
[00:06:45.930]The next ratio we'll look at its current ratio.
[00:06:49.120]To compute the current ratio,
[00:06:51.130]we take the total current farm assets
[00:06:53.150]and divide by the total current farm liabilities.
[00:06:57.310]When looking at this ratio,
[00:06:59.710]it indicates the extent to which current farm assets
[00:07:02.640]if liquidated would cover the current farm liabilities,
[00:07:06.960]the higher the ratio, the greater the liquidity.
[00:07:11.470]The limitations that go along with the current ratio
[00:07:15.280]are very similar if not almost identical
[00:07:18.990]to the ones that we talked about with the working capital.
[00:07:22.520]Into which when we talk about deferred taxes,
[00:07:26.560]the measure of the dollar amount,
[00:07:29.520]the quality of assets being measured,
[00:07:33.560]and the time constraints of the enterprises
[00:07:36.200]that we're looking at.
[00:07:38.990]One major question that I get a lot is,
[00:07:42.187]"I've calculated my current ratio,
[00:07:45.177]"but what can I do to improve it?"
[00:07:48.260]Well there are a few ways that we can go about
[00:07:51.520]improving your current ratio.
[00:07:54.840]The first one is delay any capital purchases
[00:07:58.490]that would require any cash payments.
[00:08:02.170]Again what we're gonna try and do is we wanna try
[00:08:04.750]and build up that asset side for current assets.
[00:08:09.220]And so by using cash, which is a current asset
[00:08:12.060]to go and buy say a new pickup truck,
[00:08:15.560]that would be a non-current asset,
[00:08:18.130]we're actually reducing the amount of current ratio
[00:08:22.780]that we would have had.
[00:08:25.740]The next way we go about it is we could look to see
[00:08:28.500]if any of our term loans can be re-amortized.
[00:08:32.730]If I have current liabilities that are due in this year,
[00:08:36.800]and I find a way that I can bundle those liabilities
[00:08:39.840]together and make them a non-current or a long term debt.
[00:08:46.240]I have reduced the amount of current liabilities
[00:08:49.030]therefore I can increase my current ratio.
[00:08:54.100]The next way is reduce the personal draw on the business.
[00:08:58.090]Again this goes back similar to capital purchases.
[00:09:02.430]If we're taking cash out of our business
[00:09:05.350]it's gonna hurt through the current ratio
[00:09:07.550]because we're reducing our current assets.
[00:09:10.920]The last thing that I'll suggest taking a look at
[00:09:14.070]is selling off any capital assets,
[00:09:16.273]that are not generating a return to the business
[00:09:20.020]and using the cash to reduce current debt.
[00:09:24.970]So if I've got a bunch of tractors sitting in a fence line,
[00:09:27.990]if I've got used equipment that I no longer use,
[00:09:31.810]I may want to take a look at selling that equipment
[00:09:34.600]that is a non current asset
[00:09:36.900]and turn it into a current asset.
[00:09:40.400]And I could either
[00:09:41.233]A leave it as a current asset and keep the current
[00:09:43.960]liabilities the way they are,
[00:09:45.910]or B I can use those newly found current assets ie cash
[00:09:51.910]to pay off some of my current liabilities
[00:09:53.900]and reduce the current liabilities that way
[00:09:57.790]to increase my current ratio.
[00:10:00.180]So those are just a few ideas to consider
[00:10:02.370]when looking at the current ratio
[00:10:04.200]and how I might be able to improve it.
[00:10:06.770]Next we'll look at the final ratio that we'll talk about
[00:10:11.680]in terms of the balance sheet.
[00:10:13.260]The final ratio we'll look at is the debt to asset ratio.
[00:10:17.236]It is calculated by taking total farm liabilities
[00:10:20.170]and divide them by total farm assets.
[00:10:23.420]This ratio is a measure of financial position.
[00:10:28.380]This ratio expresses what proportion of total farm assets
[00:10:31.670]is owed to creditors.
[00:10:34.200]In other words, it is the creditors claim
[00:10:37.300]against the assets of the business.
[00:10:40.840]This ratio is one way to express the risk exposure
[00:10:44.590]of the farm business.
[00:10:46.470]It can be calculated using either the cost
[00:10:49.020]or market value approach to value at farm assets.
[00:10:53.630]If using the market value approach,
[00:10:56.750]then deferred taxes with respect to the assets
[00:10:59.550]should be included as liabilities.
[00:11:04.600]This method works great when comparison between farms
[00:11:10.230]are being used.
[00:11:12.210]However if you're using
[00:11:16.320]this calculation to compare different time periods
[00:11:22.500]for an individual farm,
[00:11:24.360]the cost approach is the preferred method.
[00:11:28.180]Again the higher the ratio,
[00:11:30.370]the greater risk exposure to the farm.
[00:11:35.700]With that we have completed talking about the balance sheet
[00:11:40.380]and we will continue on
[00:11:42.230]with the other portions of the course.
[00:11:44.474](upbeat music)

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Financial Ratios

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