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.
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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.
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| 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.
