Financial Statement Analysis

Chapter 6

Financial Statement Analysis -- Chapter 6

Financial Criteria Liquidity Solvency Profitability Repayment Capacity Financial Efficiency

Liquidity• The ability to meet current financial

obligations• Structural liquidity relates to the

relationship between current assets and current liabilities

• Operational liquidity relates to cash flow measures

Liquidity Measures

• WORKING CAPITAL

Current Assets-Current Liabilities

• CURRENT RATIO

Current Assets/Current Liabilities

• CASH FLOW COVERAGE RATIO

The total cash available divided by the projected total cash required

Working Capital A measure of the amount of funds that

would be available to purchase inputs and inventory items after the sale of all current assets and payment of all current liabilities.

Current Ratio Current Assets Divided by Current

Liabilities.

The higher the ratio, the more liquid the business.

Cash Flow Coverage Ratio• The total cash available divided by the

projected total cash required.

Solvency• Evaluates what would happen if the assets are

sold and all liabilities are paid.

• A longer-term measure of the ability of the business to meet financial obligations.

Solvency Measures• DEBT-TO- ASSET RATIO

• DEBT-TO- EQUITY RATIO

• EQUITY-TO- ASSET RATIO

Debt to Asset Ratio EXPRESSES TOTAL LIABILITIES AS A

PROPORTION OF TOTAL ASSETS

INFLUENCED BY THE VALUE PLACED ON THE ASSETS

A REASONABLE STANDARD FOR THE RATIO WILL VARY FROM ONE TYPE OF ENTERPRISE TO ANOTHER

Debt to Equity Ratio LEVERAGE RATIO

REFLECTS THE EXTENT TO WHICH FARM DEBT CAPITAL IS BEING COMBINED WITH EQUITY CAPITAL

A RATIO OF LESS THAN 1:1 MEANS THAT CREDITORS HAVE LESS MONEY IN THE BUSINESS THAN THE OWNER.

Equity to Asset Ratio EXPRESSES THE PROPORTION OF TOTAL

ASSETS FINANCED BY THE OWNER’S EQUITY CAPITAL

THE MIRROR IMAGE OF THE DEBT-TO- ASSET RATIO

Profitability• RETURN ON ASSETS

• RETURN ON EQUITY

• OPERATING PROFIT MARGIN RATIO

Return on Assets MEASURES THE RATE OF RETURN ON ASSETS

AND IS OFTEN USED AS AN OVERALL MEASURE OF PROFITABILITY

NET FARM INCOME FROM OPERATIONS + INTEREST EXPENSE - UNPAID OPERATOR AND FAMILY LABOR AND MANAGEMENT DIVIDED BY AVERAGE TOTAL ASSETS

Return on Equity MEASURES THE RATE OF RETURN ON

OWNER’S EQUITY EMPLOYED IN THE BUSINESS

NET FARM INCOME FROM OPERATIONS - UNPAID OPERATOR AND FAMILY LABOR AND MANAGEMENT DIVIDED BY AVERAGE TOTAL EQUITY

Operating Profit Margin Ratio MEASURES THE RETURNS TO CAPITAL PER

DOLLAR OF GROSS FARM REVENUE

NET FARM INCOME FROM OPERATIONS + INTEREST EXPENSE - UNPAID OPERATOR AND FAMILY LABOR AND MANAGEMENT DIVIDED BY GROSS FARM REVENUES

Long Run Un-profitability

• THERE ARE ONLY THREE WAYS THAT A BUSINESS CAN REMAIN UNPROFITABLE AND SURVIVE IN THE LONG-RUN:

(1) USE NON-FARM INCOME TO OFFSET FARM LOSSES,

(2) THE BORROWER IS INHERITING OR BEING GIFTED MONEY FASTER THAN THE BUSINESS IS LOSING IT,

(3) THE VALUE OF THE BUSINESS ASSETS ARE APPRECIATING FASTER THAN THE BUSINESS IS LOSING MONEY.

Repayment Capacity• TERM DEBT AND CAPITAL LEASE COVERAGE

RATIO

• CAPITAL REPLACEMENT AND TERM DEBT REPAYMENT MARGIN

• DEBT-TO-INCOME RATIO

Term Debt and Capital Lease Coverage Ratio PROVIDES A MEASURE OF THE ABILITY OF A

BORROWER TO COVER ALL REQUIRED TERM DEBT AND CAPITAL LEASE PAYMENTS

Financial Efficiency

ASSET TURNOVER RATIO

MEASURES HOW EFFICIENTLY ASSETS ARE BEING USED TO GENERATE REVENUE

THE HIGHER THE RATIO THE MORE EFFICIENT ASSETS ARE BEING UTILIZED

WHEN THE ASSET TURNOVER RATIO IS MULTIPLIED BY THE OPERATING PROFIT MARGIN THE RESULT IS THE RATE OF RETURN ON ASSETS

A BUSINESS HAS TWO WAYS TO INCREASE TOTAL BUSINESS PROFITS:

INCREASE PROFITS PER UNIT PRODUCED

OR

INCREASE THE VOLUME OF PRODUCTION WHILE MAINTAINING THE PROFIT PER UNIT

ONE OF THE PROBLEMS IN AGRICULTURE IS THAT THE INDUSTRY AS A WHOLE HAS A LOW ASSET TURNOVER RATIO AND LOW OPERATING PROFIT MARGIN, RESULTING IN A LOW RETURN ON ASSETS

OPERATING EXPENSE RATIO

MEASURES THE PROPORTION OF GROSS FARM REVENUES BEING SPENT FOR OPERATING EXPENSES

OTHER EXPENSE RATIOS ARE:

DEPRECIATION EXPENSE RATIO

INTEREST EXPENSE RATIO