Financial Analysis PDF

Financial Analysis DXP02703 —UN—23FEB11 INTRODUCTION DXP01796 —UN—28SEP10 The manager's ability to analyze the...

Financial Analysis DXP02703 —UN—23FEB11 INTRODUCTION DXP01796 —UN—28SEP10 The manager's ability to analyze the financial situation compare the ratios over time for the same farm business. of the farm or ranch operation contributes to the ability The direction of the trend is often more important than of that operation to succeed. For this reason, accurate the actual value. financial statements are an integral part of farm and ranch management. They are a tool the manager can use to Comparative analysis is comparing the farm’s ratio to help monitor the financial progress of the business and to other similar operations. Many state extension services compare current performance with past performances. keep databases on financial ratios for different classes and sizes of farms and ranches. The manager must be The large capital investment required in farming and cautious when conducting comparative analysis due to the ranching today makes obtaining additional financing an degree of accuracy of accounting data. The comparisons important area for the manager to understand. Few should be used as clues to managerial performance. farm and ranch managers can afford to operate on a cash basis. Without complete and accurate financial The use of financial ratios to evaluate farm management statements, credit may be difficult to obtain. has become more common over the past few years. This chapter provides definitions and interpretations of the In chapter 2, the net worth statement and income more common financial ratios used in agricultural financial statement were introduced. In this chapter, we will look management. The ratios take information from the at the various measures to evaluate and monitor the financial statements and use it to provide an evaluation of financial health of the farm business. several financial aspects of the business. The ratios are divided into measures for: All management decisions, operating and financial, are eventually reflected in the farm’s financial statements. Liquidity Analyzing financial statements with ratios can provide Solvency some useful insights into the financial health of the Profitability business. Financial efficiency Two common ways to perform ratio analysis are trend analysis and comparative analysis. Trend analysis is to SP63763,3BAA1C9 -19-17JUL14-1/1 3-1 090117 PN=41  Financial Analysis LIQUIDITY Working capital Liquidity is the ability of a business to generate enough Debt structure cash to pay bills without disrupting business operations. Asset structure Liquidity measures determine the ability to meet short The liquidity ratios for the Kendalls’ farm are shown in term debt and other obligations from available cash or Fig. 1. other current assets. The liquidity measures include: Current ratio Fig. 1 — Liquidity Formulas and Calculations for the Kendalls’ Farm Business Current Ratio Year 1 Year 2 Current Assets $347,442 $474,170 Divided by Current Liabilities $138,683 $176,976 Results Current Ratio Equals Current Ratio 2.51 2.68 Working Capital Current Assets Current Assets Current Assets $347,442 $474,170 Minus Current Liabilities $138,683 $176,976 Results Working Capital $208,759 $297,194 Debt Structure Current Liabilities Current Liabilities Equals Current Liabilities $138,683 $176,976 Divided by Total Liabilities $800,984 $825,309 Results Debt Structure 17.31% 21.44% DXP05280 —UN—22JUL14 Asset Structure Current Current Assets Assets Current Assets $347,442 $474,170 Divided by Total Assets $2,460,276 $2,713,300 Results Asset Structure 14.12% 17.48% Fig. 1 — Liquidity Formulas and Calculations for the Kendalls' Farm Business Current Ratio The current ratio is defined as the current Debt Structure Debt structure is defined as current assets (net worth statement) divided by the current liabilities divided by total liabilities. It is an indication of liabilities (net worth statement). It measures the ability of the percent of total farm debt (liabilities) that is due in the farm’s current assets, if sold, to cover the short-term one year. For the Kendalls’ farm in year two, 21.44% of liabilities. For the Kendalls’ farm in year two, the current the total farm debt is due within the next 12 months. If ratio is 2.68:1, which indicates that for every $1.00 of the Kendalls’ continue to pay off debt in the coming years current liabilities, the farm has $2.68 of current assets. without incurring new debt, the debt structure percentage The current ratio includes inventory values which have should increase. A decrease in debt structure, from one estimated market values and might not be able to be year to the next, would indicate that new term debt was sold immediately. However, current liabilities are not incurred during the year. necessarily due immediately, as both current assets and current liabilities have a one-year time horizon. Asset Structure Asset structure is defined as current assets divided by total assets. It is an indication of the Working Capital Working capital is defined as current percent of total assets that will be used or sold in one year. assets minus current liabilities. Whereas the current ratio For the Kendalls’ farm in year two, the asset structure measures liquidity as the dollars of current assets per is 17.48%. While the asset structure measure is not as dollar of current liabilities, the working capital reflects frequently used in business analysis, an asset structure the actual dollars available after current assets are sold less than debt structure can be a symptom of farm liquidity and current liabilities are paid. Whether or not working problems. It should not be used as a stand-alone liquidity capital is adequate for a farm business depends upon the measure. individual business. Working capital for the Kendalls’ farm is estimated to be $297,194. SP63763,3BAA1CA -19-23JUL14-1/1 3-2 090117 PN=42  Financial Analysis SOLVENCY Net capital ratio Solvency measures the ability of all assets, if sold at Debt to asset ratio market value, to cover all debts. A business is solvent Equity to asset ratio if total assets exceed total liabilities. Solvency also Debt to equity ratio examines the relationships between debt capital, funds The solvency measures for the Kendalls’ farm are shown borrowed and invested in the business, and equity capital, in Fig. 2. which is the owner’s funds invested in the business. The solvency measures include: Fig. 2 — Solvency Formulas and Calculations for the Kendalls’ Farm Business Year 1 Year 2 Net Capital Ratio Equals Total Farm Assets $2,460,276 $2,713,300 Divided by Total Farm Liabilities $800,984 $825,309 Results Net Capital Ratio 3.07 3.29 Debt to Asset Ratio Equals Total Liabilities $800,984 $825,309 Divided by Total Assets $2,460,276 $2,713,300 Results Debt to Asset Ratio 32.56% 30.42% Equity to Asset Ratio Equals Total Equity $1,659,292 $1,887,991 Divided by Total Farm Assets $2,460,276 $2,713,300 Results Equity to Asset Ratio 67.44% 69.58% DXP05277 —UN—22JUL14 Debt to Equity Ratio Equals Total Liabilities $800,984 $825,309 Divided by Total Farm Equity $1,659,292 $1,887,991 Results Debt to Equity Ratio 48.27% 43.71% Fig. 2 — Solvency Formulas and Calculations for the Kendalls' Farm Business Net Capital Ratio The net capital ratio is defined as total year two is 30.42%, which indicates that 30.42% of their farm assets divided by total farm liabilities. It shows the total assets are owed to creditors. The debt to asset ratio total dollar value of assets per dollar of total debt. For the can reflect trends over time for a given farm business. Kendalls’ in year two, the net capital ratio is 3.29, which The Kendalls’ debt to asset ratio decreased from year indicates that for every dollar of total debt for their farm, one to year two even though total liabilities increased, they have $3.29 in total asset values. It is important to which would indicate that during year two they borrowed note that this ratio is influenced by the value placed on all additional funds and total debt increased, but that total farm assets. Over-valuing assets would lead to inflated asset values increased proportionally more. estimates of the net capital ratio and might provide a comfort level that is not true. Any net capital ratio less than Equity to Asset Ratio The equity to asset ratio is defined one would indicate that total liabilities are greater than as total farm equity divided by total farm assets. It total assets and the farm business would be insolvent. measures the percent of total assets financed by owner’s Thus, higher net capital ratios are desirable. equity capital. An increase in the equity to asset ratio over time would indicate an increasing owner’s claim against Debt to Asset Ratio The debt to asset ratio is defined as the farm’s assets. The Kendalls’ equity to asset ratio for total liabilities divided by total assets. It measures what year two is 69.58%, which indicates they own 69.58% percent of the total assets of the farm business is owed to of the farm’s assets free and clear of debt. The ratio the creditors. This ratio is useful in measuring the amount also increased from year one to year two, indicating an of risk in regard to debt against the assets for the farm or increase in the Kendalls’ claim against the business. ranch. The debt to asset ratio for the Kendalls’ farm in Continued on next page SP63763,3BAA1CB -19-23JUL14-1/2 3-3 090117 PN=43  Financial Analysis Debt to Equity Ratio The debt to equity ratio is defined than one would indicate more equity financing than debt as total farm liabilities divided by total farm equity. It financing and vice versa. Since debt financing involves measures the relationship between debt financing and interest payments, the higher the level of debt financing equity financing by the farm. The debt to equity ratio the greater the financial risk. The debt to equity ratio for is often referred to as the leverage ratio since it reflects the Kendalls’ in year two is 43.71%, which indicates that the way debt and equity are combined to finance the debt financing is less than half of the amount of equity farm business. A ratio equal to one would indicate an financing by the Kendalls’. equal amount of debt and equity financing. A ratio less SP63763,3BAA1CB -19-23JUL14-2/2 3-4 090117 PN=44  Financial Analysis PROFITABILITY MEASURES Return on Assets Profitability measures how efficient a business is in Return on Equity generating a profit from the use of the land, labor, Cost of Debt management, and capital resources. The profitability Operating Profit Margin Ratio measures include: These measures of profitability for the Kendalls’ farm are shown in Fig. 3. Calculation of the measures requires Net Farm Income from Operations referencing the Kendalls’ income statement and net worth Net Farm Income statement. Fig. 3 — Profitability Formulas and Calculations for the Kendalls’ Farm Business Year 1 Year 2 Opportunity Cost of Unpaid Operator and Family Labor $40,000 $40,000 Average Total Farm Assets $2,435,365 $2,586,788 Average Total Farm Liabilities $723,568 $813,147 Average Farm Net Worth $1,546,769 $1,773,642 Net Farm Income from Operations $131,316 $175,038 Total Interest Paid $40,534 $48,833 Rate of Return on Assets (ROA) Equals Net Farm Income from Operations $131,316 $175,038 Plus Interest $40,534 $48,833 Minus Opportunity Cost of Unpaid Operator and Family Labor $40,000 $40,000 Equals Return to Assets $131,850 $183,871 Return To Assets $131,850 $183,871 Divided by Average Total Assets $2,435,365 $2,586,788 Results Return on Assets (ROA) 5.4% 7.1% Rate of Return on Equity (ROE) Equals Net Farm Income from Operations $131,316 $175,038 Minus Opportunity Cost of Unpaid Operator and Family Labor $40,000 $40,000 Equals Return to Equity $91,316 $135,038 Return to Equity $91,316 $135,038 Divided by Average Farm Equity $1,546,769 $1,773,642 Result Return on Equity (ROE) 5.9% 7.6% Cost of Debt (COD) Equals Total Interest $40,534 $48,833 Divided Average Total Farm Liabilities $723,568 $813,147 Result Cost of Debt (COD) 5.6% 6.0% Operating Profit Margin Ratio (OPMR) Equals Net Farm Income from Operations $131,316 $175,038 Plus Interest $40,534 $48,833 Minus Opportunity Cost of Unpaid Operator and Family Labor $40,000 $40,000 Equals Operating Profit Margin $131,850 $183,871 Operating Profit Margin $131,850 $183,871 Divided by Total Revenue $661,226 $818,820 Results Operating Profit Margin Ratio 19.9% 22.5% Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) DXP05278 —UN—22JUL14 Equals Net Farm Income from Operations $131,316 $175,038 Plus Interest $40,534 $48,833 Equals Earnings before Interest and Taxes $171,850 $223,871 Plus Depreciation $46,677 $55,646 Equals Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) $218,527 $279,517 Fig. 3 — Profitability Formulas and Calculations for the Kendalls' Farm Business Net Farm Income from Operations (NFIFO) The NFIFO is considered to be the profit from the typical operation of is defined as total revenue minus total expenses, operating the farm and ranch business. It also represents a return and fixed. From the Kendalls’ income statement, NFIFO to unpaid operator and family labor, equity capital, and is shown to be $175,038 for year two. Net farm income management. Continued on next page SP63763,3BAA1CC -19-23JUL14-1/2 3-5 090117 PN=45  Financial Analysis Net Farm Income (NFI) NFI is defined as the NFIFO plus For the Kendalls’, the ROA is 7.1% and the COD is less, any gain or loss on the sale of capital items such as land at 6.0%. Since total assets equals debt and equity capital, and machinery. Since the gain or loss on capital sales is the Kendalls’ are earning 7.1% on the debt capital while not considered a part of the normal operations of the farm, only having interest of 6.0%. The extra earnings over it is not included in NFIFO, but rather is added after the interest actually cause the ROE to be higher than the calculation of NFIFO. ROA. To summarize, consider the following: Returns on Assets (ROA) The return to assets is defined If ROA > COD, then ROE will be higher than ROA. as the NFIFO plus interest (from the income statement) If ROA < COD, then ROE will be lower than ROA. minus an opportunity cost of unpaid operator and family labor. The return on assets (ROA) is defined as the return If the COD is less than the ROA, causing ROE to be to assets divided by average total assets. greater than ROA, then the debt capital is beneficial to the farm business. Interest is added to NFIFO to give returns to unpaid operator and family labor, total capital, and management. Operating Profit Margin Ratio (OPMR) The operating By adding the interest that was subtracted in the income profit margin is defined as NFIFO plus interest minus statement, the result is NFIFO as if there was no debt the opportunity cost of unpaid operator and family for the farm. labor. Actually, the operating profit margin is the same calculation as the return to assets. The operating profit An opportunity cost for unpaid operator and family labor margin ratio is defined as the operating profit margin is subtracted to reflect a payment for the contribution of divided by total revenue from the income statement. operator and family labor that is not shown as an expense on the income statement. The opportunity cost should be In Fig. 3, the operating profit margin is shown to be an estimate of the value of the operator and family labor $183,871. The total revenue from the income statement in their next best alternatives. (year 2) is $818,820. Dividing the operating profit margin by total revenue gives 22.5%. Thus, for the Kendalls’, The NFIFO plus interest and minus an opportunity cost of their NFIFO plus interest and minus the opportunity cost unpaid operator and family labor of $40,000 gives return of unpaid operator and family labor is 22.5% of their total to assets for the Kendalls’ of $183,871. The return to revenue. Whereas ROA and ROE measure profitability as assets is divided by total asset value to give a return a percentage of assets and equity, the OPMR measures on assets. However, the question is whether to use the profitability as a percentage of the total revenue generated. beginning or ending value for total farm assets. Normally, the beginning and ending total farm asset values are Earnings before Interest, Taxes, Depreciation, and averaged to give average total farm assets (Fig. 3). The Amortization (EBITDA) The EBITDA is defined as net ROA for the Kendalls’ in year two is 7.1%. farm income from operations plus interest expenses, depreciation expense, and amortization expense. In this Return on Equity (ROE) The return to equity is defined as case, amortization expense refers to the proration of the NFIFO minus the opportunity cost of unpaid operator intangible assets and is similar to depreciation except it and family labor. The return on equity (ROE) is defined as applies to assets such as copyrights and patents. The the return to equity divided by the average total equity. EBITDA is a measure of profitability that examines the repayment capacity of the business. The EBITDA can be Whereas the ROA gives the rate of return on total assets, compared to upcoming principal and interest payments to the ROE gives the rate of return on the owner’s equity. reflect the adequacy to cover scheduled debt payments For the Kendalls’, the ROE for year two is 7.6%. on term debt. Cost of Debt (COD) The cost of debt (COD) is defined In Fig. 3, the EBITDA is shown to be $279,517 in year as total interest, from the income statement, divided by two for the Kendalls’ farm business. The scheduled term average total liabilities from the net worth statement. debt principal and interest payments for the Kendalls’ In year two, the Kendalls’ total interest is $48,833 and in the coming year are $92,812, which can be found on average total farm liabilities are $813,147. This gives a the projected cash flow budget in chapter 4. Thus, there COD of 6.0%. This is not to be interpreted as the interest appears to be sufficient funds to cover the obligations on rate on any particular loan; rather it simply gives interest as term debt. a percentage of total farm debt. However, it can be useful in estimating if debt capital is beneficial to the business. SP63763,3BAA1CC -19-23JUL14-2/2 3-6 090117 PN=46  Financial Analysis FINANCIAL EFFICIENCY Operating Expense Ratio Financial efficiency measures how effective the business Depreciation Expense Ratio is in generating revenue from the production and Interest Expense Ratio management decisions. The financial efficiency measures Net Farm Income from Operations Ratio include: The financial efficiency ratios for the Kendalls’ farm are shown in Fig. 4. Asset Turnover Ratio Fig. 4 — Financial Efficiency Formulas and Calculations for the Kendalls’ Farm Business Year 1 Year 2 Asset Turnover Ratio (ATR) Equals Total Revenue $661,226 $818,820 Divided by Average Total Assets $2,435,365 $2,586,788 Results Asset Turnover Ratio 27.2% 31.7% Operating Expense Ratio Equals Total Operating Expense Minus Depreciation $442,699 $541,303 Divided by Total Revenue $661,226 $818,820 Equals Operating Expense Ratio 66.95% 66.11% Depreciation Expense Ratio Equals Depreciation Expense $46,677 $55,646 Divided by Total Revenue $661,226 $818,820 Equals Depreciation Expense Ratio 7.1% 6.8% Interest Expense Ratio Equals Total Interest Expense $40,534 $48,833 Divided by Total Revenue $661,226 $818,820 DXP05279 —UN—22JUL14 Results Interest Expense Ratio 6.1% 6.0% Net Farm Income From Operations Ratio Equals Net Farm Income From Operations $131,316 $173,038 Divided by Total Revenue $661,226 $818,820 Results Net Farm Income From Operations Ratio 19.9% 21.1% Fig. 4 — Financial Efficiency Formulas and Calculations for the Kendalls' Farm Business Asset Turnover Ratio (ATR) The asset turnover ratio Depreciation Expense Ratio The depreciation expense is defined as the gross revenue (from the income ratio is defined as total depreciation expense divided by statement) divided by average total assets (from the net total revenue. It shows the percentage of total revenue worth statement). The asset turnover ratio measures the devoted to depreciation expense. operational efficiency by indicating the level of revenue generated per dollar of assets owned by the business. For year two, the depreciation expense ratio for the Kendalls’ is 6.8%, or total depreciation expense is 6.8% Fig. 4 shows an asset turnover ratio for the Kendalls’ of total revenue. of 31.7% for year two. The Kendalls’ assets generated 32.6% of their value in revenue, and at this rate it would Interest Expense Ratio The interest expense ratio is take approximately three years for the assets to generate defined as total interest expense divided by total revenue. their value in revenue. It shows the percent of total revenue devoted to interest. Operating Expense Ratio (OER) The operating For year two, the interest expense ratio for the Kendalls’ expense ratio is defined as total operating expenses is 6.0%, or total interest expense is 6.0% of total revenue. minus depreciation divided by total revenue. It reflects the percentage of total revenue devoted to operating Net Farm Income from Operations Ratio The net farm expenses except depreciation. Depreciation is removed income from operations ratio is defined as the net farm from operating expenses and treated as a separate income from operations divided by total revenue. It shows efficiency ratio. the percentage of total revenue that remains for net income after all operating expenses and interest have For year two, the operating expense ratio for the Kendalls’ been subtracted. is 66.11% or total operating expenses except depreciation are 66.11% of the total revenue in year two. Continued on next page SP63763,3BAA1CD -19-23JUL14-1/2 3-7 090117 PN=47  Financial Analysis operations ratio will always add up to 100%. Each of the For year two, the net farm income from operations ratio expense ratios represents a portion of total expenses, and for the Kendalls’ is 21.1%, or net farm income from net farm income is the percentage of revenue remaining operations is 21.1% of total revenue. after all expenses. The operating expense ratio, depreciation expense ratio, interest expense ratio, and the net farm income from SP63763,3BAA1CD -19-23JUL14-2/2 COMPARATIVE ANALYSIS Many states develop benchmark financial ratios for average or typical for their region. The benchmark different types and sizes of farms. A typical financial financial ratio scorecard shows ranges where the financial scorecard is shown in Fig. 5, where the Kendalls’ can ratios are vulnerable, average, and strong. compare their ratios with those that are considered Fig. 5 — A Comparative Analysis Using the Kendalls’ Financial Ratios and Regional Averages for Similar Farms Regional Averages Kendall Farm Vulnerable Average Strong LIQUIDITY Current Ratio 2.51 2:1 Working Capital Debt Structure 21.44% >20% 10% - 20%.6:1 0.3:1 - 0.6:1 1.5:1.45:1 - 1.5:1 80% 60% - 80% 20% 10% - 20% 20% 10% - 20%