Friday, September 13, 2013

Farm Financial Analysis Tool Proves Useful in Analyzing Solvency and Liquidity

By Miguel Saviroff, Extension Educator, Somerset County

For a farmer, making economic decisions may be a stressful task if accounting records and financial statements are not available.  The use of spreadsheets and computerized financial records help farmers relax while making a plan. Penn State Extension Farm Management Educators have used FINPACK as one of the tools in training farmers to evaluate the farm’s financial position, explore alternatives, and make informed farm management decisions. There are, of course, other financial programs that can be purchased for this use.
Dave Van Pelt is fine tuning and monitoring his operation's current financial strategies. He used FINPACK to simulate expansion strategies and analyze the possible new challenges. “My experience with FINPACK was with dairy start-up strategies, it has helped me see the level of production needed to support a herd large enough to meet financial obligations,” said Van Pelt.
The road map of a farm financial analysis starts at the beginning of the year with a beginning balance sheet. Once this point of reference is set, a monthly cash flow is planned and compared with the actual at the end of each month. At the end of the year, the accounting cycle closes and an ending balance sheet is prepared. Both balance sheets are used to calculate inventory changes and a year-end analysis leads to an Income Statement. Financial performance can be assessed using three concepts: Profitability, Liquidity, and Solvency.

In the FINPACK program using the data entry mode, a complete listing of assets, liabilities, and ownership equity is fed into the system, and the program creates the beginning balance sheet. Assets and liabilities are listed as current, intermediate, and long term. The output section presents this balance sheet with assets in order of liquidity in one section, and liabilities and net worth in the other section, with the two sections "balancing."  Owner’s Equity (aka Net Worth) is the difference between the assets and the liabilities, and it should be more that 50% of total assets. For example, assume my total assets are worth $800,000 and my total liabilities are $320,000. My owner’s equity would be $480,000 ($800,000 - $320,000). Owner’s equity should increase between 2 consecutive balance sheets. An owner’s equity growth rate should be at least 6% annually. If the business does not grow it could be a sign of liquidity problems, such as an income decrease.

FINPACK provides a suite of tools that guide producers 
and ag professionals to sound financial decisions. 
Two financial ratios obtained from the balance sheets are found in the FINPACK output screen. They are the liquidity and the solvency ratios. The liquidity ratio states the ability of the farm to pay its short term obligations. The liquidity ratio is also known as the current ratio and is obtained by dividing current assets by current liabilities. For example, if your current assets are $20,000 and your current liabilities are $16,000, then your current ratio would be 1.25 ($20,000 / $16,000). We interpret this ratio as follows: you have $1.25 of current assets (cash, savings, etc.) for every $1.00 of obligations (i.e. loan payments, line of credit or accounts payable) you owe within the upcoming year. A ratio greater than 1.7 is “Strong”; a 1.7 to 1.1 would fall in the “Caution” range; and less than 1.1 would be “Vulnerable.” A “vulnerable” situation can have potential causes, such as a farm expansion, low returns and high costs, and rapid debt payments. Strategies to get out of this “liquidity crunch” include raising cash by partially liquidating (selling) non-current or non-essential assets or borrowing to meet the current liabilities. Restructuring current debt into non-current debt reduces current liabilities. Debt restructuring should not be the first alternative in trying to solve liquidity problems. Other alternatives may need to be tried to provide a faster infusion of capital.

The solvency ratio indicates the financial position of the farm, and whether the business can cover its total debts with its asset base. A business is “insolvent” if it has more debts than it has in assets. The Debt to Assets ratio measures a farm’s solvency and is calculated by dividing total liabilities by total assets. From the above example, my debt/asset ratio would be 40% ($320,000 / $800,000). This measure helps us compare our solvency to similar operations.

A Debt to Asset Ratio less than .3 (30% debt) should be comfortable; between .3 and .6 (30% to 60% debt) is a medium to heavy load; and over .6 (60% debt) becomes heavy and if high enough, impossible to service. Overcoming a poor solvency measure will depend on the cause. A new operation will be expected to have a poor solvency. It will require hard work, strong cash flow, and solid profitability over time. In general, selling unneeded assets and using the proceeds to pay down your debts, can work. Refraining to take on additional debt can possibly help. You will need to increase your asset base by reinvesting your profits in the operation or bringing in outside investors. Also important, is taking good care of the assets by preventative maintenance, so they will hold their value longer.

In my next blog article,  I will discuss cash flow, financial efficiency, repayment ability, and profitability, which are highly important areas when looking at the overall financial condition of an agribusiness.

For information on Farm Financial Management educational programs, or if you have questions on financial aspects of your farm business, contact Miguel Saviroff at Penn State Extension in Somerset County at 814-445-8911 extension 144.

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