Financial Check Up

John B. Penson, Jr.Regents Professor and

Stiles Professor of AgricultureTexas A&M University

Seen the Doc Lately? Benefits from an

annual financialfinancial checkup.

Treadmill stress test your financialfinancial strength.

Get your visionvision examined.

What is the status of your…. Liquidity? Solvency? Profitability? Efficiency? Debt

repayment capacity?

Survivability?

Key Financial Indicators Sweet 16 Financial Indicators

Farm Financial Standards Council www.ffsc.org

Focus today on a few key indicators of liquidity, solvency, profitability, financial efficiency, debt repayment capacity and the implications for survivability.

Measures of Liquidity

1. Current ratioCurrent ratio:• Current assets divided by current liabilities.• Demonstrates ability to cover scheduled current liabilities for the coming year out current assets and still have “cash” left over.• Should exceed 1.0exceed 1.0 to be technically liquid.• Some firms fail despite exceeding this hurdle.

Measures of Liquidity

1. Current ratioCurrent ratio:• Current assets divided by current liabilities.• Demonstrates ability to cover scheduled current liabilities for the coming year out current assets and still have “cash” left over.• Should exceed 1.0exceed 1.0 to be technically liquid.• Some firms fail despite exceeding this hurdle.

2. Working capitalWorking capital:• Current assets minus current liabilities.• Expresses liquidity in dollars rather than ratio.• Should be positive.• Cash is King!Cash is King!

Liquidity TrendsCurrent Ratio

0.00

0.501.00

1.50

2.00

2.503.00

3.50

4.00

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity TrendsCurrent Ratio

0.00

0.501.00

1.50

2.00

2.503.00

3.50

4.00

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MinimumMinimum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity Trends

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measures of Solvency

1. Debt ratioDebt ratio:• Total debt divided by total liabilities.• Demonstrates ability to liquidate the firm, cover all liabilities out of all assets, and still have “cash” left over.• Should not exceed 0.50not exceed 0.50 to minimize financial risk exposure.• Some firms fail however at lower levels.

Measures of Solvency

1. Debt ratioDebt ratio:• Total debt divided by total liabilities.• Demonstrates ability to liquidate the firm, cover all liabilities out of all assets, and still have “cash” left over.• Should not exceed 0.50not exceed 0.50 to minimize financial risk exposure.• Some firms fail however at lower levels.

2. Leverage ratioLeverage ratio:• Total debt divided by equity or net worth.• Often a credit standard in loan approval decisions.• Should not exceed 1.0not exceed 1.0 to minimize financial risk exposure.• Effects of rising interest rates.

Solvency Trends

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Solvency Trends

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MaximumMaximum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measures of Profitability

1. Rate of return on assetsRate of return on assets:• Net farm income before interest and taxes divided by average farm assets during the year.• Demonstrates the accrual adjusted pre-tax return to management total capital invested in the farm operation. • Should be positivepositive; the higher the better.

Measures of Profitability

1. Rate of return on assetsRate of return on assets:• Net farm income before interest and taxes divided by average farm assets during the year.• Demonstrates the accrual adjusted pre-tax return to management total capital invested in the farm operation. • Should be positivepositive; the higher the better.

2. Operating profit margin ratioOperating profit margin ratio:• Net farm income before interest and taxes divided by gross farm revenue.• Demonstrates accrual adjusted income per dollar of goods sold.• Typically in the 10-30 percent range10-30 percent range.

Profitability TrendsRate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Profitability TrendsRate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MinimumMinimum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measure of Debt Repayment Capacity

1. Term Debt and Capital Lease Coverage RatioTerm Debt and Capital Lease Coverage Ratio:• Funds available from operations to cover scheduled payments divided by scheduled principal payments on term loans and capital leases.• After provision for taxes and withdrawals. • Should be greater than 1.0greater than 1.0. • Non-farm income often factored in by lenders.

Measure of Debt Repayment Capacity

1. Term Debt and Capital Lease Coverage RatioTerm Debt and Capital Lease Coverage Ratio:• Funds available from operations to cover scheduled payments divided by scheduled principal payments on term loans and capital leases.• After provision for taxes and withdrawals. • Should be greater than 1.0greater than 1.0. • Non-farm income often factored in by lenders.

2. Capital Replacement and Term Debt MarginCapital Replacement and Term Debt Margin:• Funds available from operations to cover scheduled payments and replace aging equipment and buildings.• After provision for taxes and withdrawals.• Should be positivepositive; the higher the better.

Debt Repayment Capacity

Net Cash Income-to-Total Debt

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Some Conclusions…. Indicators of Indicators of

growth/survival:growth/survival: Increasing liquidity Increasing solvency Increasing debt

repayment capacity Increasing

profitability

Indicators of Indicators of potential potential failure:failure: Declining liquidity Declining solvency Decreasing debt

repayment capacity

Decreasing profitability

Tale of Two Cities…Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Tale of Two Cities…Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Tale of Two Cities…

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Tale of Two Cities…

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

Net Cash Income-to-Total Debt

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1 2 3 4 5

Year Before Failure

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Historical Analysis A look backwards

like the Beaver study.

Comparison of current performance with past performance.

Recommend doing this at the enterprise level as well as for the farm as a whole.

Rate of Return on Assets

0.000.010.020.030.040.050.060.070.080.090.10

1 2 3 4 5

Prior Years

Historical Analysis A look backwards like

the Beaver study. Comparison of current

performance with past performance.

Recommend doing this at the enterprise level as well as for the farm as a whole.

Reasons underlying unwanted trends such as the declines in declines in last two years?last two years?

Rate of Return on Assets

0.000.010.020.030.040.050.060.070.080.090.10

1 2 3 4 5

Prior Years

Comparative Analysis Comparing current

performance with similar operations like the Beaver study.

Benchmark analysis at enterprise level when possible.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

Comparative Analysis Comparing current

performance with similar operations like the Beaver study.

Benchmark analysis at enterprise level when possible.

Address reasons why your firm is performing more poorly than other comparable operations before it before it is too lateis too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

Pro Forma Analysis Stress testingStress testing current

expected cash flows by varying prices, unit costs and yields.

Look at implications of longer run price and unit cost trends on future financial future financial healthhealth when making major decisions.

Forces of change…. Impacts of rising unit costs

of production inputs. Prices, costs and yields can

all affect the financial health of the firm.

Failure to account for the risk associated with adverse trends can lead to failure of the firm.

Sources of Uncertainty Global trends in

production and consumption

Energy prices and core inflation trends

Interest rates and exchange rates

WTO and the 2007 farm bill

Reading the Road Signsin Financial Statements

Some Signs Are Confusing…

Signs to Avoid…

Some signs were hard to read in the 1980s...

What we saw when things became clear in the 1980’s

Ignoring adverse trends has its consequences….

Any Questions?Any Questions?