Economics and Competitiveness
Purpose | Focus | Using financial ratios to analyze operations | Interpreting the ratios | Definition and interpretation of ratios and margins | Liquidity measures | Solvency measures | Profitability measures | Financial efficiency measures| Debt coverage| Closing remarks
The use of financial ratios and margins in assessing, benchmarking and monitoring farm performance has become more common over the past few years. This has complemented producers' efforts to define the economics of producing farm commodities, tying economic performance at the enterprise level to financial performance at the farm level. The purpose of this document is to provide definitions and interpretations of the more common financial ratios and margins employed in agriculture.
Much of the text of this document is excerpted from a 1996 Alberta Agriculture report on "Farm Financial Ratio Analysis(1)". This is supplemented by excerpts from a publication by Dr. David Kohl on "Understanding Key Financial Ratios and Benchmarks"(2) and the "Blue Book"(3), rounding out the list of useful ratios and margins and providing further interpretation and application. References arising from each of the latter two sources are noted specifically.
The context of the definitions in this document is relative to the business analyses / research reports generated by the Production Economics Section (Alberta Agriculture, Food & Rural Development) through its Whole Farm Data Base (WFDB) / Profit$ program. Financial ratios and margins are defined and interpreted using the methods and format used in this program. Strengths and weaknesses of the WFDB / Profit$ approach relative to standard accounting procedures will be highlighted as they arise.
Whereas this document focuses on definitions and interpretation, two other documents in this series are:
(2) Sample Calculations:
(3) Summary of Key Ratio Calculations & Benchmarks(4):
- provides examples of ratio and margin calculations based on a sample farm analysis generated through the Whole Farm Data Base / Profit$ program, and
These documents will enable users to generate their own comparable financial ratios and margins, plus serve as a reference to related Production Economics research postings.
- provides ratio "performance" benchmarks, as well as a summarization of the formulas used to derive each of the key ratios and margins.
Using Financial Ratios to Analyze Operations
As all production, operating and financial decisions are eventually reflected in the financial statements, analyzing financial statements can reveal some useful insights into the strengths and weaknesses of an operation. Comparing an individual's ratio values to a group is just one step in the financial analysis process.
There are two main levels that ratio analysis can be carried out. The first level, and the most useful application of ratio analysis, is to compare the ratios to a farm's past performance. Carried out over a period of time, this will produce a trend. This process can be referred to as a trend analysis. The direction of the trend is often more important than the value itself. For example, a low return on assets may be acceptable if the direction is steadily increasing.
The second level at which ratio analysis can be carried out is at the industry level. The purpose of this is to compare the farm's performance to other similar operations. This can be referred to as comparative analysis. The most obvious application is to compare the value of ratios against others in the industry. This must always be done with caution as the degree of accuracy in the collection of accounting data is often questionable. Use the information as clues to performance and not as an unquestioned judgement on an operation. The user should try to avoid labeling a value as good or bad. A ratio value must be viewed in the context of many ratios and the overall operating strategy.
Another useful application of comparative analysis is to supplement it with trend analysis. Some of the variability in the values of a farm's ratios could be due to a larger industry wide trend. For instance, a drop in return on assets is obviously an undesirable event. However, if the industry as a whole has experienced a reduction, then the drop for an individual farm must be considered in this context. That is, part of the downturn may be explained by general economic or weather related factors that are out of the control of the manager to some degree.
Interpreting the Ratios
There are a few general comments to keep in mind when interpreting the value for a ratio:
Dr. Kohl's work on financial ratios has provided a series of benchmarks for judging performance and risk associated with each. These are noted as "green, yellow and red lights".
- Foremost, a ratio is nothing more than one number divided by another, so there is nothing inherently revealing about the value of one, or even several, ratios. Ratio analysis is nothing more than a tool to help understand the business.
- Be careful when assigning a judgement to a value as being too high, too low or just right. This will depend upon the circumstances of the operation and the overall strategy of the farm. Moreover, a value must be viewed within the context of the other ratio values.
- There are many inherent measurement problems. There are compelling arguments for the use of both cost and market values. Production Economics Branch research typically employs estimated market valuation of assets ... this presents the problem of accuracy. It is difficult to get an objective measure of the value of some assets. Thus the user should allow for "slack" in the values to account for this fact.
- Seasonality hampers comparability. As ratios are calculated at a point in time, the timing of the calculations with respect to the seasonal pattern on the farm is important.
- Standard methods in the literature use the term "Gross Revenue" in many of the ratio calculations. The WFDB / Profit$ program employs the "Value of Production" (VOP) concept. Revenues are adjusted for values of purchases and inventory change during the fiscal / calendar year to define the value of commodities produced. VOP has been substituted for Gross Revenue in the definitions. Use of VOP may cause comparability problems with performance measures generated under different definitions.
A table noting performance / risk benchmarks is provided in the third item in this series.
- "A green light represents low risk, a yellow light corresponds to moderate risk, and a red light means high risk. A green light doesn't guarantee success, nor does a red light imply failure. A weakness in one area may be overcome by strengths in other areas.(5)
Definition and Interpretation of Ratios and Margins
The ratios are grouped into five areas: (1) liquidity, (2) solvency, (3) profitability, (4) financial efficiency, and (5) debt coverage.
Ratios in this category are designed to measure a firm's ability to pay its obligations.
|= ||Total Current Farm Assets/Total Current Farm Liabilities |
The current ratio gives an indication of a farm's ability to meet its cash obligations coming due within the next year. A value below one could indicate a developing cash flow problem. Having a very high value may not be desirable either. It may indicate that too high a level of assets are tied up in conservative investments that have lower rates of return.
The valuation problems are not as significant given the liquid nature of the assets. However, the time of the measure is important as the time of year may have an influence on inventory amounts and values.
|= ||Total Current Farm Assets - Total Current Farm Liabilities|
Working capital and current ratio have similar issues. A positive value is desirable, but too large a value may indicate too many "lazy" assets are being held.
California Working Capital Rule (6)
|= ||Working Capital/Total Farm Expenses|
This ratio enables an assessment of adequacy of working capital relative to business expenses. Care should be taken in adjusting for large inventories and/or valuation issues.
Ratios in this category are designed to measure the long-run solvency of a farm. They are concerned with the levels of equity and debt in the farm.
Debt/Asset (D/A) Ratio
|= ||Total Farm Liabilities/Total Farm Assets|
This ratio represents the level of debt to assets for a farm. This type of ratio is often referred to as a leverage ratio. It is a good indicator of the level of financial risk associated with the farm.
The D/A ratio can be difficult to interpret. There is nothing inherently wrong with a high debt, provided the operation is very efficient and can service the debt. Also, young farmers who start out will tend to be highly leveraged and are just as likely to support their operation with off farm income. These producers may have efficient operations with a high return on assets. It is just that by the time they make their interest and principal payments, there may be little income left to provide for living expenses. A high D/A ratio is not necessarily bad in this situation.
Having a D/A ratio of zero is not necessarily a desirable goal either. Financial theory dictates that we should be earning a higher return on our equity than our debt. The theory goes that as debt payments get first claim on profits, and equity is a residual return, equity needs a higher return to compensate for this risk. Assuming that the operation is efficient and has a high return on assets, then it is desirable to assume an acceptable level of debt in order to "lever up" return on equity.
However, one thing is clear; a high D/A level involves a higher degree of financial risk. Furthermore, it is clear that higher debt levels will require a higher return on assets to service the debt.
Equity / Asset Ratio
|= ||Total Farm Equity/Total Farm Assets|
This ratio is a variant of the D/A ratio. Caution is advised in using this ratio in that it is extremely sensitive to low equity levels and/or situations where large amounts of leased assets are employed.
Debt / Equity Ratio
|= ||Total Farm Liabilities/Total Farm Equity |
This is also a variant of the D/A ratio and subject to the same cautions as with the equity/asset ratio.
|= ||Total Liabilities/Net Farm Income|
This ratio represents the number of years it would take to reduce the debt level to zero if all of the income of a farm could be directed towards principal reduction. It relates the level of debt to the ability of the farm to generate income to repay the debt.
Many of the same issues that relate to the debt to asset ratio also apply to debt payout. The real strength in the debt payout ratio is in trend analysis. If the trend is upward, this implies that the debt load is increasing at a greater rate than farm income. This trend can not be sustained over the long run and is a warning signal of future financial stress. The comparative analysis is useful here in that it can help to determine if the farm's trend is due to individual farm factors or is caused by general economic or weather factors.
Ratios in this category are designed to measure a firm's ability to generate profit.
Value of Production (VOP)
|= ||Farm Cash Receipts + (Change in Value of Product Inventory + Change in Value of Accounts Receivable) - Livestock Purchases |
This amount represents the accrued value of commodities produced during the fiscal (or calendar) year.
Net Farm Income (NFI)
|= ||Value of Production - Direct Costs - Capital Costs|
This is not a ratio by definition, but it is included as it represents the bottom line for farms and a starting point for analysis. The problem with net farm income is that it does not relate the income to the size of the investment. This is the advantage of using return on assets as a measure of profitability.
This margin represents the excess of revenue over the cost of goods sold. Gross margin indicates funds available to cover unallocated fixed costs, returns to unpaid operator & family labour, and returns to owner's / share holder's equity.
Cash Operating Margin(8)
|= ||(VOP - Production Inventory Change - Accounts Receivable Change) -
- (Direct Costs - Supplies Inventory Change - Accounts Payable (Change)
- (Capital Costs - Depreciation)
The Cash Operating Margin essentially "un-accrues" the farm income statement. It represents the cash available to cover principal payments; net cash capital acquisitions; and family living withdrawals.
Return on Farm Assets
|= ||(NFI + Interest Expense - Unpaid Operator & Family Labour/Total Farm Assets
= Return to Assets/Total Farm Assets
This ratio represents the total income generated from the farm divided by the total assets employed to generate this income. Unpaid family labour is subtracted as it represents a non-cash expense. This adjustment helps to compare farms which pay family wages to those that do not.
Before undertaking comparisons in this group, consider as to whether assets are valued at cost or at market. With market valuation, the confidence in the value will depend upon the accuracy of the appraisal of the property. Allow for a certain amount of "slack" in comparisons to account for this. A strength of ROA is in that it does not differentiate on how the operation is financed as interest payments are included in income.
Return on Farm Equity
|= ||(NFI - Unpaid Operator & Family Labour)/Total Farm Equity
= Return to Farm Equity/Total Farm Equity
This ratio represents the income generated from the owner's investment in the farm business. As is the case for return on assets the estimate of market values will have a large impact on the value. In fact, the effect will be even more exaggerated for return on equity than for return on assets.
The return on equity should be higher than the return on assets over the long-run. This assumes that the manager is using debt leverage for an advantage. There is a trade-off here between a high return on equity and high risk as the two are positively correlated.
Operating Profit Margin Ratio
|= ||(NFI + Interest Expense - Unpaid Operator & Family Labour/VOP
= Return to Farm Equity/Value of Production
This ratio measures the portion of each dollar of revenue that trickles down to the income statement to profits. A low profit margin can be compensated for with a higher asset turnover. Thus this ratio must be viewed in the context of the capital turnover. Highly capitalized operations tend to have a higher profit margin combined with a low capital turnover.
Net Farm Income less Net Government Transfers
|= ||NFI - (Government Program Receipts - Government Program Premiums) |
This ratio is a measure of a farm's dependence on government transfers for income. As the level of government support continues to drop, this ratio will become less significant.
Financial Efficiency Measures
Ratios in this category are designed to measure a firm's ability to generate revenues and control costs.
Capital (Asset) Turnover Ratio
|= ||Value of Production/Total Farm Assets |
This ratio is a measure of capital intensity. A lower value is acceptable if it represents a capital intensive operation with a higher profit margin. If a lower value is combined with a low profit margin, it signifies an inefficient operation. As is the case with return on assets, the valuation of the assets will have a large impact on the value. As market values are used, the value for capital turnover will be lower than if cost was used. Beware of this fact if comparing against capital turnover values based on cost.
Operating Expense Ratio (excludes depreciation and interest)
|= ||Operating Expenses (excluding interest and depreciation)/VOP |
This ratio represents the percentage of operating expense that will consume every $1 of revenue. A useful way to view the ratio is that the residual represents the amount of money left on a dollar of revenue that remains to:
For example, a 75% ratio would indicate that there is 25 cents from every dollar of revenue generated left to cover debt servicing, reinvestment, and withdrawals.
- service debt (both interest and principal),
- provide for reinvestment in capital assets such as machinery, equipment and buildings, and
- provide for family living withdrawals.
In general, the lower the OER, the better. This will result in more cash from every dollar of revenue generated left to cover debt servicing, reinvestment, and withdrawals. However, it should also be recognized that farms that have low debt levels can get by with a higher OER. Their mix of debt servicing, reinvestment, and family withdrawals can lean more heavily towards withdrawals without sacrificing debt servicing or reinvestment. Conversely, farms that are highly leveraged will require a lower OER to be able to service the debt and maintain an adequate level of investment. This states an obvious truth, to take on more debt requires greater efficiency the operation.
Another major consideration in the analysis relates to the operating strategy of the farm. If the farm has a low cost-of-production strategy, or if the farm does not require high levels of reinvestment to maintain the productivity of the farm, then that farm can operate at a higher level of OER and still be as profitable as other operations.
Depreciation Expense Ratio
|= ||Depreciation Expense/Value of Production |
This is likely the weakest ratio relative to the Production Economics' WFDB / Profit$ program methodology due to the programs method of calculating depreciation.
Depreciation is based on an imputed cost based on market values. Ideally, depreciation expense should be based on the original cost of the assets and reflect the actual use of the asset. If the appropriate cost base were available, a properly calculated depreciation expense ratio provides an important measure of the capital costs incurred by a farm.
Interest Expense Ratio
|= ||Interest Expense/Value of Production |
This ratio relates the interest expense to a farm's ability to generale income. This is a particularly useful ratio as it can be measure accurately. This is a ratio where the trend is vitally important. A trend upward will lead to eventual financial stress.
Ratios in this category are designed to measure a firm's ability to generate funds to meet debt obligations.
Interest Coverage Ratio
|= ||(Net Farm Income + Interest Expense)/Interest Expense |
This ratio is similar to the interest expense ratio, but it relates interest expense to earnings before interest. It provides a truer picture of debt servicing ability than the interest expense ratio as it accounts for expenses. The tradeoff is in the reliability. Net farm income includes non-cash expenses, such as depreciation, that are estimated.
Term Debt Coverage Ratio
|= ||(NFI + Depreciation - Unpaid Operator & Family Labour + Term Interest)/ Scheduled Annual Term Interest & Principal Payments |
This is another variation on the interest coverage ratio. The earnings are adjusted to account for cash flow by adding back in depreciation and subtracting out unpaid labour (which is used as a proxy for family withdrawals). Principal payments are included with the interest payments to get a clearer picture of cash flow obligations of debt. The weakness of this ration is the estimate of unpaid labour and reduces the reliability of the values.
A variation of this may be calculated to incorporate non-farm income and capital leases. This may be particularly significant in showing the potential reliance on income from not-farm sources in retiring debt.
Debt Payment / Income Ratio(9)
|= ||Scheduled Annual Term Interest & Principal Payments
(NFI + Depreciation + Interest on Term Debt)
The debt payment / income ration measures the ability of a business to service debt over the term of the loan. Once again, this ratio can provide an indication of the reliance on income from non-farm sources in retiring debt.
Financial ratios can be useful in managing the farm business by providing a check on the performance of assets and a warning as to potential areas or risk. Combining these ratios with an economic analysis of production costs and returns should provide farm managers with an excellent basis for decision making. As with many other tools, however, these ratios and margins do not guarantee success, but use of them will certainly improve the probability of success.
|1.|| Alberta Agriculture, Food & Rural Development, "Comparative Financial-Ratio Analysis for Alberta Farms", Production Economics Branch; Farm Business Management Branch, March 31, 1996. |
|2.||Kohl, David, & Troy Wilson, "Understanding Key Financial Ratios and Benchmarks", Northwest Farm Credit Services, Business Tools Bulletin, Spokane, Washington, 1997. |
|3.||Farm Accounting Standardization Review Committee (FCC), "Farm Accounting Standardization Manual", May, 1991.|
|4.|| Kohl, David, Ibid,pg.11 |
|5.|| Kohl, David, Ibid,pg. 2 |
|6.|| Kohl, David, Ibid,pg. 5 |
|7.||Farm Accounting Standardization Review Committee (FCC), Ibid,pg. 33|
|8.||This margin has been created specifically for use with the WFDB / Profit$ program to approximate cash residuals from the farm income statement as the program does not currently generate a cash flow statement. This margin has been defined for practical interpretation and is not supported by the accounting profession. |
|9.||Kohl, David, Ibid,pg. 4 |
Prepared by: Supervisor, Prod Economics Unit, Markets and Economics Division;
Ph: (780) 427-5390 or E-mail Dale Kaliel