Important financial numbers for dairies (Proceedings)

With the current economy, everyone is becoming increasingly interested in discussing financial numbers with farms. However, the numbers do not tell the whole story. It is important to determine the goals of the farm prior to jumping into evaluating the numbers. The goals of the farm may be drastically different than the farm down the road, and their financial goals may be extremely different. For example, one farm may be interested in expansion because their son/daughter has decided to return home to run the family farm. Or the farmer has decided that he is interested in retiring and spending the rest of his life taking trips to visit the grandchildren. Both of these farms interest in their financial numbers are drastically different.

As veterinarians, we have been trained to look at production numbers, somatic cell counts, pregnancy rates, and many others; however we rarely get the opportunity to look beyond production to the actual financial numbers of an operation.

To begin a financial evaluation it is first important to determine where the farm is at this point in time. Otherwise, we are unable to make predictions or suggestions regarding the direction the farm would like to go. The overall financial status of farm is best determined by looking at three financial statements: statement of cash flows (including withdrawals and non-farm income), income statement (on accrual basis), and balance sheet with assets valued at costs and market value.

Cash flow statements are important because they help to determine is their adequate cash available to service debt obligations, pay owner, etc. The cash flow summary can be determined by determining net cash from operations (operating income minus operating expenses), net capital (capital asset sales minus capital purchases), net loans (new loans minus principal repayments), and net non-farm cash (non-farm income minus non-farm uses of cash). This is the best measure to determine in-flow and out-flow of cash for the farm.

Balance sheet (net worth statement) determines the present condition of a business at a set point in time. This statement is based on the equation: Assets = Liabilities + Equity. Assets examples include such entities owned that have value including cash, equipment, land, cows, and buildings. For the balance sheet, it is important to determine assets based at cost and fair market value to get a true determination of what is occurring on the farm. Liabilities are any obligations of an entity to transfer assets to or perform services for. Examples of liabilities include loans on equipment or cattle. Equity is defined as the difference between assets and liabilities. Equity is sometimes referred to as net assets, and it is one of the best measurements of solvency for the farm.

Income statement provides information about an entity's financial performance during a specific time period. The income statement equation is based on the equation: Revenues – Expenses + Gains – Losses = Net Income (or Net Loss). Revenues are increases in net assets that occur from selling products (milk, replacements, etc). Expenses are defined as sacrifices of future value of assets used to generate revenue (e.g., purchased feed). Gains are defined as increases in net assets (equity) that result from incidental or peripheral events (e.g., calves born). Losses are defined as decreases in net assets that result from incidental or other peripheral events (e.g., cow deaths).

Since there are no "Generally Accepted Accounting Principles" for farm businesses, it has been difficult to make comparisons between different farms. With the advent of the Farm Financial Standards Council, a more standardized (but not perfect) method of reporting is being adopted by farm lending institutions, accountants and others. These criteria are known as the "Sweet 16" financial measures that most lending institutions use for evaluating financial fitness of a farm business. In this economy of failed lending institutions, more institutions are looking for some measure of confidence that the borrower will be a relatively low risk to repay both principal and interest.

The areas covered in the "Sweet 16" include liquidity, solvency, profitability, repayment capacity, and financial efficiency.

Liquidity is used to determine the ability of a business to meet its financial obligations. The two most common numbers used to determine this are current ratio and working capital. Current ratio is determined by total current farm assets ÷ total current farm liabilities. It is usually expressed as a number: 1 indicating the extent to which current farm assets if liquidated would cover current farm liabilities. Typically, higher ratios indicate greater liquidity. The other number used for liquidity is working capital. Working capital is computed from total farm assets minus total current farm liabilities. This is a theoretical measure of amount of funds available to purchase inputs and inventory after sale of current farm assets and payment of all current farm liabilities. Larger operations typically require larger working capital. Because the number generated is positive or negative, it is difficult to compare across farm businesses.

Solvency is ability of farm to meet obligations created by its long term debt. Currently there are 3 primary measures of solvency used including debt/asset ratio, equity/asset ratio, and debt/equity ratio. Debt to asset ratio is determined by total farm liabilities ÷ total farm assets. This ratio helps express the risk exposure of farm business. Higher ratios are indicative of greater risk exposure for the business. Equity to asset ratio is determined by total farm equity ÷ total farm assets. This describes the owner's claims against the assets. Higher ratios indicate the more total capital supplied by owner (s) and less by creditors. It is most useful when using market value of farm assets for comparison between farms. Debt to equity ratio is determined by total farm liabilities ÷ total farm equity. This ratio reflects the extent to which farm debt capital is being combined with farm equity capital. The higher the value of the ratio indicates more total capital supplied by creditor (s) and less by the owner (s).

Profitability of a farm is used usually based on rate of return on farm assets, rate of return on farm equity, operating profit margin ration, and/or net farm income. Rate of return on farm assets is determined by (Net farm income from operations + Farm interest expense – Owner withdrawals) ÷ Average Total Farm Assets. The higher values indicate more profitable farming operation. Owner withdrawals must be calculated otherwise severe over/under valuations may occur. Rate of return on farm equity is determined by (Net farm income from operations – Owner withdrawals for unpaid labor and management) ÷ Average total farm equity. The higher values indicate a more profitable farming operation. Deferred taxes and owner withdrawals must be included or severe over/under valuations may occur. Operating profit margin ratio is determined by (Net farm income from operations + Farm interest expense – Owner withdrawals for unpaid labor and management) ÷ Gross Revenue. This ratio measures profitability in terms of return per dollar of gross revenue. If asset turnover ratio is multiplied by operating profit margin ratio, the result is rate of return on assets. Also, net farm income must be based on pre-tax basis. Net farm income is determined as mentioned previously based on matching revenue and expenses plus the gain or loss on sale of farm capital assets before taxes. This net farm income can be interpreted as return to farmer for unpaid labor, management and owner equity.

Repayment capacity measures the ability of farm to repay loans and capital leases. This takes into account loans from all sources. It is best measured using term debt and capital lease coverage ratio (TDCL) and capital replacement and term debt repayment margin. Term debt capital lease coverage ratio is determined by (net farm income from operations +/- Total miscellaneous revenues/expenses + Total non-farm income + depreciation/amortization expense + Interest on long term debt + Interest on capital leases – Total income tax expense – Owner's withdrawals (total) ÷ (Annual scheduled principal and interest payments on term debt + Annual scheduled principal and interest payment on capital leases). The greater the ratio over 1:1 indicates greater margin to cover the payments. Capital replacement and term debt repayment margin is determined by net farm income +/- total miscellaneous revenue/expense + depreciation/amortization expense – total income tax expense – owner withdrawals = capital replacement and term debt repayment capacity – payment on unpaid operating debt from a prior period – principal payments on current portions of term debt – principal payments on current portions of capital leases – total annual payments on personal liabilities = capital replacement and term debt repayment margin. It allows lenders to evaluate ability of farmer to generate funds necessary to repay debts with maturity dates longer than one year and to replace capital assets.

Financial efficiency is determined by the use of asset turnover ratio, operating expense ratio, depreciation/amortization expense ratio, interest expense ratio, and net farm income from operations. Asset turnover ratio is determined by gross revenue ÷ average total farm assets. This ratio measures how efficiently farm assets are used to generate revenue. Higher ratios indicate that assets are more efficiently being used to generate revenue. Operating expense ratio is determined by (Total operating expense – Depreciation/amortization expense) ÷ gross revenue. Depreciation/Amortization expense ratio is determined by depreciation/amortization expense ÷ gross revenue. Interest expense ratio is determined by total farm interest expense ÷ gross revenue. Net farm income from operations is determined by net farm income from operations ÷ gross revenue.

As easily noticed from this article, it can be quite confusing and time-consuming to generate or even find information to calculate these numbers. In most small farm operations, it is difficult to have all the information, and many times educated guesses are made to reach conclusions, and some numbers may not be determined. Table 1 is listing of goals that many consultants are using for farm evaluations.

Table 1: "Sweet 16" Summary Sheet

References

"Financial Guidelines for Agriculture Producers, 1997". Downloaded March 24, 2009 from http://agmarketing.extension.psu.edu/Business/PDFs/FinGuidAgProd.pdf

Reed, B and Welch, D. "Introduction to Dairy Farm Business Consulting". American Association of Bovine Practitioners Pre-Conference Seminar 26. Charlotte, NC. 2008.