Understanding Financial Ratios and Benchmarks
Historically, great production drove success in agricultural businesses. To maintain long-term success in today’s volatile and highly competitive marketplace, leaders in ag businesses still have to be great producers, but also have to be sophisticated financial managers. One critical aspect of financial management is to understand and interpret your business’ financial position, performance and progress towards achieving goals. Financial statements and record-keeping systems provide the foundation and data, but ratios and benchmarks enable managers to interpret financial information to make decisions and evaluate performance.
Financial ratios are measures of financial performance and position. Ratios provide a mathematical relative comparison of one piece of financial information to another, and can be used to:
- Evaluate profitability, efficiency and risk
- Assess short-term risk bearing ability (liquidity)
- Assess overall financial position (solvency
- Determine capacity for growth
- Drive performance
- Make informed business decisions
Benchmarks are guidelines or ‘rules of thumb’ for industry or business segment-specific financial ratio targets. Benchmarks also include peer comparisons that evaluate financial ratios relative to a group of similar businesses. Benchmarks are presented in many ways, but one common approach uses the following reference points for each ratio or measure:
Green: Low Risk - Normal or healthy range for an industry/segment
Yellow: Moderate Risk - Slightly outside normal/ healthy range
Red: High Risk - Significantly outside normal/ healthy range
Note: While benchmarks provide general guidelines, a green light doesn’t guarantee success, nor does a red light imply failure. An operation may overcome weakness in one area with strengths in other areas. Variations may occur between industries.
Who uses ratios and benchmarks?
Financial ratios and benchmarks are useful to decision makers inside and outside a business. Management uses the information to assist in decision making, goal setting and to compare business performance to other operations. Lenders, investors and other creditors use the same information to evaluate risk, return and performance compared to a portfolio of loans or investments.
To measure progress over time, users should calculate financial ratios on a regular basis at similar times in the business cycle. Ratios can help identify symptoms of underlying problems in a business and enable managers to focus attention on key issues. Basing decisions and priorities on objective measures like financial ratios reduces the likelihood that the management team will make decisions solely on intuition, ‘gut feel’ or emotion.
Where can I get benchmarks for my business?
Financial ratios are most useful with benchmarks that help determine if you’re in the ‘green’ or ‘red.’ The easiest way to get specific information for your industry is to ask your lending relationship manager. They’ll use our database of peer studies to compare your results to others in your industry and/or region. If peer data is not available for your industry or operation, they’ll compare your results to the benchmark guidelines used to evaluate your operation’s financial performance and risk profile.
Various public and private organizations also collect and analyze financial data on the agricultural and specific industries. These include the Risk Management Association and Farm Financial Standards Council, among others. Ratio guidelines for general agriculture, retail, wholesale, service, and manufacturing firms are available for purchase through these organizations. Refer to the end of this document for general agricultural benchmarks from the Farm Financial Standards Council.
Before You Start
Strategy and Goals: Understanding and interpreting financial information first requires a clear assessment of personal and business goals. Without a sense of business direction and strategic priorities, it is very difficult to determine if the business is positioned to achieve owners’ goals and objectives. For example, an operation preparing for significant growth or expansion will require significantly more cash or liquidity (for down payments and funding additional operating expenses) than a business preparing to reduce in size or scale. With strategies and goals in mind, managers and owners can begin to assess financial performance and ratios.
Information Needed: Financial ratios require information from multiple financial statements. Before you start, prepare your operation’s balance sheet and annual income statement or profit and loss statement as of the same date. While the ratios are very interrelated, there are subtleties to interpretation that managers must consider. Some ratios are measured at a single point in time, which varies depending upon the particular point in the production cycle. Others encompass a certain time period or an entire operating cycle. As such, trends become important in understanding the relative progress of an operation.
Key Financial Ratios
Basic financial ratios are grouped into management categories that help decision makers assess business performance from multiple perspectives. The best assessments reference more than one financial ratio in each basic management category.
IMPORTANT NOTE: The benchmarks referenced for each measure below are based on work completed by the Farm Financial Standards Taskforce and Council and represent benchmarks for ag businesses across the United States and in all commodities. These benchmarks provide highlevel guidelines only, and do not reflect the unique attributes of each industry, region or segment. Benchmarks vary from industry to industry, and managers should address specific circumstances with an expert before making decisions based on benchmark information.
Ratios and benchmarks presented in this document may not directly align with Northwest FCS’ loan underwriting standards. Benchmarks are based on information from the Farm Financial Standards Taskforce and Council and are representative of national averages across all agricultural commodities. Measures are not industry or segment-specific.
Liquidity is the measure of an operation’s shortterm cushion for risk, including availability of cash and near-cash assets to cover short-term obligations without disrupting normal business operations.
Key liquidity ratios include:
- Current Ratio
- Working Capital
- Working Capital to Total Expenses
In many agricultural businesses, the family is an integral part of the operation, and business and personal liquidity must both be examined. Financial analysts like to see a business or the owners maintain two to six months of family living expenses in cash or near-cash assets. This serves as a safety net in the event of a business hardship, disability of the operator, or other misfortune. A lack of adequate cash for family living can spill over into business disputes, and ultimately cause financial problems.
To increase an operation’s liquidity, a manager can:
- Structure debts to carefully balance operating needs and long-term debt reduction
- Develop and follow marketing plans to match timing of cash flows and increase operating profits
- Reduce production costs
- Sell assets
- Raise equity capital
Solvency and Leverage Ratios
Solvency or leverage addresses the relationship between assets and obligations, including the respective investment levels of both owners and creditors.
Key solvency and leverage ratios include:
- Debt-to-Asset Ratio
- Equity-to-Asset Ratio
- Debt-to-Equity Ratio
Three ratios are commonly used to measure solvency. While all three ratios provide the same basic information on the leverage position of the business, they show the information from different perspectives. Select the solvency ratio that makes the most sense for your operation.
Managing Solvency and Leverage
Solvency and leverage measure the company’s entire balance sheet position, but do not reflect the operation’s ability to meet ongoing cash obligations. Other factors, such as management skill and debt structure, impact how ratios should be interpreted. The reasons for equity growth should also be examined. For example, growth through earnings is looked upon more favorably than growth from inflation or inheritance. Growth generated from the profits should be identified to accurately gauge the real progress of a business and its future potential.
The type of operation is also an important determinant of healthy leverage or solvency measures. As with all financial measures, an ideal benchmark is specific to your segment of the industry.
Strategies to increase equity and manage leverage include:
- Increase operating profits through a combination of:
- Increasing prices, quality, volume, or added value to production
- Improving production efficiencies
- Make additional principal payments, where prudent
- Avoid unnecessary capital expenditures
- Control family living withdrawals from the operation
Profitability compares business revenues against all economic costs and evaluates how productively a business is utilizing its human and capital resources.
Key profitability ratios include:
- Operating Profit Margin
- Return on Assets
- Return on Equity
Profitability is one of the most important, yet underemphasized measures of financial performance. Although a business can operate in the short-run on break even or negative returns, profits are necessary in the long-run to support the family, build equity, service debt and sustain the business. If not remedied, inadequate profits may result in repayment, liquidity and solvency problems in the operation, sometimes as long as two to five years down the road.
To be meaningful, profitability analysis requires true earnings information. In agriculture, operations can maintain and report cash basis accounting records, but this leaves many owners knowing more about how much tax was paid than what actual profit the operations made. Decision makers should use accrual income information to analyze profitability accurately. Trends in income and profitability are useful to observe. Steady or increasing profit levels are desirable, while erratic profits are a sign of instability and may indicate a need for more robust risk management strategies.
Strategies to increase profitability include:
- Aggressively monitor and increase efficiencies of production costs
- Reduce unproductive capital or human assets
- Reduce costs (especially in the operation’s largest expenses)
- Improve revenue through increased volume or quality of production
- Proactively manage interest rate risk and interest costs
- Maintain adequate working capital to take advantage of cash discounts from suppliers
Repayment Capacity Ratios
Repayment capacity is the ability of a business to support the family’s living expenses, meet all expenses and debt payments, replace depreciating capital assets and prepare for the future through business investments and retirement plans.
- Term Debt and Lease Coverage Ratio
- Term Debt and Lease Coverage Margin
Managing Repayment Capacity
Meeting financial obligations is important, and when a business does not generate sufficient funds in a given period to fund required payments, it relies on the strength of the balance sheet (liquidity and solvency) or equity from owners to fund shortfalls. While profitability and cash generated by the business may vary from year-to-year, trends in coverage are very important to watch closely.
To protect against adversity and position for unexpected opportunities, an operation needs cushion in the margin to cover debt payments. The relative level required may change depending on business needs. In periods of expansion, having higher coverage margins helps mitigate risks. In a growing business, maintaining adequate margins protects against cost overruns or problems in production or marketing. Conversely, an operation that is stable/downsizing and has fixed rate debt or significant/reliable non-farm employment can maintain an acceptable risk profile with a smaller coverage margin. This is true especially if living expenses and income tax payments are low.
In all cases, however, the lower the coverage ratio, the more important risk management tools become. These include crop and property insurances, liquidity, hedging, options or contracted production.
Strategies to manage repayment capacity include:
- Increase net farm income through:
- Improved quality, price, or amount of production
- More effective marketing
- Sale of capital assets (short-run strategy)
- Reduce operating expenses
- Increase off-farm earnings
- Closely monitor family living withdrawals and reduce if necessary
- Restructure debt
Ag businesses spend a significant amount of time managing costs and expenses, and efficiency ratios enable managers to determine what strategies work and what strategies don’t. Evaluating efficiency ratios over time allows decision makers to identify expenses that are increasing or decreasing disproportionately to the operation’s size and scale.
Strategies to increase financial efficiency:
- Aggressively monitor and reduce production costs where prudent
- Increase the quality, amount and value of production
- Improve marketing practices
- Keep family living withdrawals to a minimum
- Properly structure debt
While a particular ratio can provide insight into financial performance, trends in the ratios are even more useful. A trend is a direction or tendency exhibited by a ratio over two or more years. Positive or negative trends for three to five years are considered significant. Managers should also watch for a lack of trends, or erratic financial performance, as this can be a sign of instability due to management problems, insufficient risk management or other factors. When making financial projections, be conservative to avoid overestimates. Projections of ratio improvement of more than 5 percent should be carefully scrutinized, as cost savings, price increases and other variables are often overestimated.
Interrelationships among the ratios and benchmarks
The financial ratios and benchmarks presented in this publication are interrelated and should be considered together. A conclusion should not be reached based on one ratio. For example, an operation can maintain high leverage if combined with strong liquidity and repayment ability.
While a strength in one area can help offset a weakness in another area, the operation must be analyzed as a whole.