To thrive in ranching, you must pay close attention to operation finances; otherwise, you may barely survive in the business. Financial analysis can be complicated and hard-to-learn by non-accountants and as a result, many ranchers tend to leave the task to a Certified Public Accountant (CPA). It is fine to let a CPA do the calculations, but we must know how to interpret the results so we can use them to make needed adjustments in our management plan.
Stan Bevers, Texas A&M AgriLife Extension Economist, discussed financial analysis at the 2013 Next Generation Agricultural Conference in Bryan, Texas and most of the following information is taken from his presentation.
An analysis should be prepared from a good management information system that contains accurate accounting records, production inventories, and asset listings. The asset listing should include the depreciation schedule. A complete analysis includes financial position, production and financial performance, and production and financial projections. Only financial position and financial performance will be discussed in this article.
Three statements are used to determine financial position – a beginning balance sheet prepared on the first day of the accounting year, an annual income statement and an ending balance sheet prepared on the last day of the accounting year. These documents, along with production data, serve as the core for analyzing production and financial performance.
“The amount of funds the owner has in the business is shown on a balance sheet and is determined by listing owned assets and liabilities with their values,” says Danny Klinefelter, Texas A&M AgriLife Extension Economist. “The difference between assets and liabilities is net worth, or the owner’s equity in the business.”
“Assets may include cash on hand, bank accounts, accounts receivable, feed supplies, livestock, equipment, buildings, land and other items,” says Klinefelter. “Although each asset may not be completely paid for, its full value is listed. The unpaid accounts, notes and mortgages are listed as liabilities.”
An income statement provides operating results for a specific period of time, such as a calendar year. The income statement can also be called an earnings report, operating statement or profit-and-loss (P&L) statement. Revenues and expenses are shown on an income statement.
The operation’s financial performance is measured by liquidity, solvency, profitability, repayment capacity and efficiency. All values used in the measurements are taken from the balance sheet and income statement.
Liquidity is the ability to meet short-term debt obligations and is determined by a liquidity ratio and the amount of available working capital. The liquidity ratio is calculated by dividing current assets by current liabilities. Working capital is the amount of funds on hand to cover annual expenses required to run the operation.
Solvency is the ability to pay long-term debt and the interest on that debt. Three ratios are used to determine solvency – equity to asset, debt to asset and debt to equity. Equity is the ownership interest in the ranch and assets are owned resources that have future economic value, can be measured and can be expressed in dollars. Examples of assets include cash, investments, accounts receivable, inventory, supplies, land, buildings, equipment, and vehicles.
“The equity to asset ratio measures the equity amount in the ranch when compared to the total owned assets,” says Adam Kantrovich, Michigan State University Extension. “It is calculated by dividing net worth by total assets. Any ratio less than 70 percent puts a ranch at risk and may lower its borrowing capacity. If a ranch has an equity to asset ratio of 49 percent, then 51 percent of the business is essentially owned by someone else, usually the bank.”
Debt to asset ratio measures the ranch debt when compared to its total assets and is determined by dividing total liabilities by total assets. Any ratio higher than 30 percent puts a ranch at risk and lowers its borrowing capacity.
“Percentage of the ranch owned by creditors versus the amount owned by the owner/operator is the debt to equity ratio,” continues Kantrovich. “This ratio indicates how much of the ranch has been leveraged in debt. It is typically used by creditors to quickly determine the amount of risk they will be taking by providing financing.”
Profitability can be measured by return on assets (ROA), return on equity (ROE) and operating margin. ROA is the ratio of annual net income to average total asset value during the financial year. Average total asset value is determined by adding the total value of assets in your possession at the first of the year and again at the end of the year and dividing the total by two. Return on assets measures your efficiency in using assets to generate net income. For example, if you have a return on asset value of 0.21 percent, you earn 21 cents on every dollar you have invested in assets.
Rate of return on equity is calculated by dividing net income by average total equity. This ratio measures the rate of return on equity capital used in the ranch business. Equity capital includes money, supplies, animals and equipment. The value of equity capital is computed by adding estimated current market value and subtracting total liabilities.
Operating margin ratio shows operating income as a percentage of revenue or sales and is calculated by dividing operating income by revenue. Operating income is income minus operating expenses. Operating margin ratio of ten percent means that a net profit of ten cents is made on every dollar of sales. The higher the value of the operating margin, the more revenue converted to operating income and the more profit made by the ranch. Operating margin ratio can be improved by increasing revenue, reducing operating costs or both. Net income from operations is another measurement of profit and is calculated on a pre-tax basis.
Repayment capacity is measured by 1) term debt and capital lease coverage ratio and 2) capital replacement and term debt replacement margin.
“The term debt and capital lease coverage ratio measures your ability to pay term debt and capital lease payments prior to the purchase of any other assets,” write Bradley Zwilling and Dwight Raab in the February 15, 2013 issue of farmdocDaily. “The calculation looks like this:
Net Ranch Income From Operations
Plus: Total Non-Farm Income
Plus: Interest on Term Debt and Capital Leases
Less: Income Tax Paid
Less: Family Living Expense
Divided By: Annual Scheduled Principal and Interest Payments on Term Debt and Capital Leases
As this ratio increases, ability to pay debt and capital lease payments will increase as well. A ratio of 1:1 indicates the ability to meet your term debt and capital lease obligations. A ratio in excess of 1:1 indicates a margin available to deal with short-term cash flow difficulties and the presence of cash to take advantage of alternative opportunities. A ratio of less than 1:1 indicates inability to pay term debt obligations.”
Capital replacement and term debt repayment margin is computed in the following way:
Net Ranch Income from Operations
Plus: Depreciation/Amortization Expense
Less: Total Income Tax Expense
Less: Withdrawals for Unpaid Labor and Management (Family Living)
Equals: Capital Replacement and Term Debt Repayment Capacity
Less: Payment on Unpaid Operating Debt from a Prior Period
Less: Principal Payments on Current Portions of Term Debt
Less: Principal Payments on Current Portions of Capital Leases
Equals: Capital Replacement and Term Debt Repayment Margin
This measure enables borrowers and lenders to evaluate the ability of the ranch owner to generate funds necessary to repay debts with maturity dates longer than one year and to replace capital assets. It also enables users to evaluate the ability to acquire capital or service additional debt and to evaluate risk margin for capital replacement and debt service.
Financial efficiency is measured by asset turnover, operating expense, depreciation expense, interest expense and net ranch income ratios. The asset turnover ratio is calculated by dividing net sales by the average total assets. This measurement indicates how successfully a ranch is using its assets to generate revenue. If a ranch can generate more sales with fewer assets, it has a higher turnover ratio which shows that the manager is using assets efficiently. A lower turnover ratio shows that the manager is not using ranch assets optimally.
“An operation expense ratio shows the proportion of income that is being used to cover operating expenses, not including principal and interest on loans,” says Kantrovich. “The lower the percentages, the healthier a ranch is financially. A number less than 60 percent means the ranch is on strong footing while anything higher than 80 percent means the ranch is more vulnerable to market changes.”
The amount of income required to maintain capital is the depreciation expense ratio. The ratio for the ranch should be no higher than five percent for it to be considered financially strong. A percentage higher than 15 percent means the ranch may be depleting its capital too quickly.
“Interest expense ratio represents the amount of gross income that is being spent to pay interest on borrowed money,” Kantrovich continues. “This ratio should be no higher than five percent for the ranch to be financially sound. An interest expense ratio higher than ten percent indicates the ranch is spending too much of its gross income to pay interest on borrowed money.”
“Percentage of income left after payment of all expenses with the exception of unpaid labor and management is the net income ratio,” Kantrovich states. “This ratio should be no lower than 20 percent for the ranch to be considered financially strong. A percentage less than 10 percent indicates the ranch is either spending too much of its gross income on expenses or not deriving enough income.”
It is not necessary to use all of the above-described measurements to determine the financial health of your ranching business. Select the ones that will answer the important questions. A CPA can help you make these decisions and assist in building your comfort level with their use.