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Better Decisions Five top ratios to measure your business's financial progress Using the right ratios to measure your profitability, efficiency, liquidity and solvency can give you a good handle on how well your farm is really doing by JOHN MOLENHUIS Although it may be hard to imagine, there are some people that do not find financial analysis particularly appealing. Part of the problem may be that there are so many different financial measures from which to choose. If you are looking for some quick "hits," there are some key ratios that can reveal a lot about your operation. First, let's separate financial measures into four main categories -- profitability, financial efficiency, liquidity and solvency. Profitability is well known and measures how well the business is able to generate a profit. Financial efficiency refers to how effective the business is at using its assets to generate income. Liquidity assesses your ability to pay your bills as they come due. And, finally, solvency determines how much you are relying on debt to finance the business. By category, here are my top five ratio picks and how they are calculated. Profitability: Operating profit margin ratio = (Net farm income + interest expense) divided by gross farm income Return on assets = (Net farm income + interest expense) divided by total assets Efficiency: Asset turnover = Gross farm income divided by total assets Liquidity: Current ratio = Current assets divided by current liabilities Solvency: Debt-to-equity ratio = Total liabilities divided by equity. Perhaps the easiest way to talk about the ratios is to walk through an example. Table 1 presents a summary of the financial results for Joe and Jolene Farmer. Their balance sheet results are reported on the left and their income statement on the right. Table 1. Joe and Jolene Farmer - 2005 financial summary Balance sheet* Income statement Current assets $112,000 Gross farm income $250,000 Total assets (A) $1,100,000 Interest expense $14,000 Current liabilities $56,000 Net farm income** $21,000 Total liabilities (B) $267,000 **In addition to all their expenses, a value for unpaid labour and management has been deducted from gross farm income to arrive at net farm income Equity (A-B) $833,000 * Assets valued at estimated market value Drawing from the information supplied in Table 1, Table 2 calculates the five financial measures and reports them in the "J & J" column. The last column provides an industry target for each of the measures. These targets are good starting points, but they can vary depending on your farm type. It is important not to look at individual ratios in isolation. A weakness in one area can be compensated for by strengths in others. Table 2. Financial Measures for Joe and Jolene Farmer - 2005 Ratio Calculation J & J Target Operating profit margin (profitability) (Net farm income + interest expense) / Gross farm income ($21,000 + $14,000) / $250,000 0.14 Greater than 0.20 Return on assets (profitability) (Net farm income + interest expense) / Total assets ($21,000 + $14,000) / $1,100,000 0.03 Greater than 0.05 Asset turnover (efficiency) Gross farm income / Total assets $250,000 / $1,100,000 0.23 Greater than 0.40 Current ratio (liquidity) Current assets / Current liabilities $112,000 / $56,000 2.0 Greater than 1.5 Debt to equity (solvency) Total liabilities / Equity $267,000 / $833,000 0.32 Less than 0.40 First, the good news is that J & J are in good shape in terms of their liquidity and solvency. A current ratio of 2.0 indicates that they have $2 of current assets for every $1 of current liabilities. Current assets are those short-term assets that can be easily turned into cash. Current liabilities are bills that are going to come due within the next year. They are also in a decent equity position, with a debt-to-equity ratio of 0.32. They should be able to weather short-term financial downturns or meet all their financial obligations if they were ever to sell off all their assets. The bad news is that they fall short in profitability and efficiency. An operating profit margin of 0.14 means that they should look to increase their net farm income by improving their cost control or reviewing their marketing plan to increase the price they receive. Both the return on assets and asset turnover measures are showing that the business assets are not being used effectively. This can suggest that J & J are over-capitalized with too many assets or assets that are larger than they need. Things to consider may be expanding production to match equipment or building size, doing some custom work to increase equipment usage or selling non-productive assets. If you are one of those people who doesn't find this stuff riveting, get hold of someone that does. A good business advisor will help you with our decisions and work with you to measure your progress. Finding a good advisor has become a lot easier with the Farm Business Assessment service available through the Canadian Farm Business Advisory Service (CFBAS). For a $100 fee, eligible producers can receive up to five days' worth of consulting advice. A qualified private-sector farm business advisor reviews your farm's past and current situation and works with you to develop a financial plan for increasing your profitability. "Worth every penny! We really were quite satisfied with our services" and "It gave a clearer picture of our operation's performance -- strong points and weak points" are just a couple of the positive comments received from producers who have used the service. For more information on CFBAS, call toll-free at 1 866 452-5558 or visit their website at www.agr.gc.ca/renewal. BF John Molenhuis is OMAFRA's Business Analysis and Cost of Production Program Lead, based at the OMAF Brighton Resource Centre. He can be reached by phone at (613) 475-9472 or by e-mail at john.molenhuis@omaf.gov.on.ca. © copyright 2006AgMedia Inc.. top back