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Measuring Financial Performance: A Critical Key to Managing Risk

Dr. Laurence M. Crane


Director of Education and Training
National Crop Insurance Services, Inc.

The essence of managing risk is making today; replacement--what one would have to
good decisions. Correct decision making pay to acquire a replacement today; and,
depends on accurate information and proper book value--the historical cost minus
analysis. This article discusses common depreciation. For various reasons, farmers
financial information and performance and their lenders often use market value
measures frequently used by farmers and whereas accountants generally prepare a
lenders to evaluate farm financial health and balance sheet using the asset's book value.
make risk management decisions. By An increasingly common practice is to
conducting regular checkups on financial prepare a balance sheet with two columns of
condition and performance, farmers are values – one for book value and the other for
more likely to treat causes rather than market value.
address only symptoms of problems.
Sometimes farmers develop more than
Financial Statements one balance sheet. One balance sheet is to
Financial statements help assess the reflect their business and another is prepared
financial well-being of the overall farm. for their personal situation. Differentiating
Information about the financial results of between personal and business assets helps
each enterprise (enterprise budgets) and to recognize which assets are part of the
physical asset is important for enterprise business and which are outside the business.
management decisions, but by themselves Two balance sheets also separate business
are inadequate for certain decisions because debts from personal debts. Similarly, it may
they do not describe the whole-farm be necessary to prepare several balance
business. An understanding of the farm's sheets to show the portion of the farm that is
overall financial situation and enterprise attributable to a co-owner of the business.
relationships requires three key financial
documents: the balance sheet, the income A completed balance sheet shows
statement and the cash flow statement. information such as the total value of assets,
total indebtedness, equity, available cash
The balance sheet summarizes the and value of liquid assets. This information
values of the farm's owned assets and can then be analyzed to determine the
liabilities. The difference between the two business' current ratio, its borrowing
totals is the owners' equity (net worth). capacity and opportunities to attract equity
Leased assets are not included in the balance capital.
sheet because the farmer does not own them
(even though these assets are part of the An income statement reports the
farm's productive capacity). amount of profit the business generates.
Usually income statements are prepared on
One question that arises in preparing a an annual basis. An accrual income
balance sheet is what values should be used. statement often provides a better measure of
Frequently used valuation methods include: the farm's performance and profitability
historical--what the asset cost when it was because it considers changes in inventory
acquired; market--what one could sell it for rather than only cash transactions. It is for

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this and other reasons why an income tax help the farm manager identify past mistakes
return should not be relied on as measuring and learn from them by not repeating those
the farm's profit. same mistakes again.

A cash flow statement reports the A word of caution: the need for accurate
sources and uses of the farm’s cash record keeping is critical because decisions
resources. Such statements not only show are no better than the information they are
the change in the farm's cash resources based on. Financial measures derived from
throughout the year, but also when the cash incomplete or inaccurate information are
was received or spent. An understanding of typically misleading and can lead to bad
the timing of cash receipts and expenditures business decisions. The value of farm
is critical in managing the whole-farm. records was discussed in the “Record
Neither an income tax return nor an income Keeping; Essential to Risk
statement provides the same information as Management”article.
a cash flow statement.
Several types of analysis are appropriate.
Because cash flow analysis is only At a minimum, farmers should evaluate their
concerned with covering cash expenses, it is performance over time. Comparing
important to remember long-term financial documents from past years is
survivability depends on covering important useful because they reveal trends or patterns.
non-cash needs. For example, machinery Comparing current statements to past
depreciation and unpaid farm management statements reveal what has been happening
and labor are two critical non-cash expenses. to the farm business' financial situation. The
The farm operation that does not generate balance sheets show changes in owner's
sufficient cash to cover depreciation, and the equity and risk exposure (whether they have
farmer, who provides his management and been increasing, decreasing or remaining the
labor for free, is on a dangerous downhill same); the income statements reveal trends
slide. For this reason, carrying a level of in profit; and, the cash flow statements can
crop insurance that helps to consistently help the farmer understand the timing of
generate a positive cash flow, as opposed to cash availability and needs.
only a zero cash flow covering cash
expenses, is critical to long-term survival of The information from these three
the farm. Using cash flow analysis as a financial statements also can be used to
means of determining an appropriate level of prepare additional financial measures that
insurance coverage was discussed in the reveal the strengths and weaknesses of the
article “Cash Flow Analysis of the MPCI farm. These additional financial measures
Purchase Decision. can be used to make several comparisons.

Using the Information from Financial First, the current performance of the
Statements farm can be compared to its historical and
The primary objective of financial projected or budgeted performance. This
record keeping and analysis is to make comparison helps farmers understand how
better business decisions. Identifying and why the actual outcome of the business
emerging problems and initiating timely differs from what they had expected.
corrective action, as well as identifying
potential opportunities for increased profit, Second, the farm's performance can
are some of the obvious benefits of financial be compared to that of its peers, or similar
analysis. Hopefully, ongoing analysis will farm businesses, to determine the relative

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status. A farm’s performance that is below as they come due, without disrupting the
the average indicates that additional profits normal, ongoing operations of the business.
are possible because others (peers) are Liquidity can be analyzed both structurally
proving it is possible to be more productive. and operationally. Structural liquidity refers
The key is to identify why and take to balance sheet measures of the
appropriate management action. These relationships between assets and liabilities
comparisons are very useful but sometimes and operational liquidity refers to cash flow
difficult to do because of the personal nature measures. A frequent cause of liquidity
of the information. However, farm financial problems occurs when debt maturities are
information that can be used to compare not matched with the rate at which the
farm businesses is available through business’ assets are converted to cash.
Extension reports and farm record-keeping
organizations. Two recommended measures
of liquidity are the current ratio and
A third comparison can be made working capital. The current ratio measures
between the performance of the farm the relationship between total current farm
business and non-farm alternatives. This assets and total current farm liabilities and is
last comparison identifies opportunities, if a relative measure rather than an absolute
any, that are lost or relinquished because one dollar measure. The higher the ratio, the
has invested their time and capital in owning more liquid the farm is considered to be.
and operating a farm. Working capital is a measure of the amount
of funds available to purchase inputs and
Financial Performance Measures inventory items after the sale of current farm
The Farm Financial Standards Council assets and payment of all current farm
developed the Financial Guidelines for liabilities. Working capital is expressed in
Agricultural Producers, a set of absolute dollars; therefore, determining
recommended standardized farm financial adequate working capital is related to the
factors, measures and reporting formats size of the farm operation.
farmers can use to better understand their
farm business. The recommended measures Solvency measures the amount of
for financial analysis are grouped into five borrowed capital used by the business
broad categories: liquidity, solvency, relative the amount of owner’s equity capital
profitability, repayment capacity and invested in the business. In other words,
financial efficiency. These standard solvency measures provide an indication of
performance measures, sometimes referred the business’ ability to repay all
to as the “sweet 16”, are discussed below indebtedness if all of the assets were sold.
and their formulas are summarized in Table Solvency measures also provide an
1. Obviously, past and present financial indication of the business’ ability to
information are not the only factors affecting withstand risks by providing information
a farm’s financial performance. Keep in about the farm’s ability to continue
mind that monitoring the “sweet 16” operating after a major financial adversity.
measures as a group is more important than
focusing on only one or two measures at the Unlike liquidity, solvency is
exclusion of others. concerned with long-term as well as short-
term assets and liabilities. Solvency
measures evaluate what would happen if all
Liquidity measures the ability of the assets were sold and converted into cash and
farm business to meet financial obligations all liabilities were paid. The most

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straightforward measure of solvency is the farm business. It is useful to consider
owner equity, using the market value of the ROE in relation to ROA to determine if
assets and including deferred taxes in the the farm is making a profitable return on
liabilities. As with working capital, their borrowed money.
adequacy of equity depends on business The operating profit margin
size, making comparisons difficult without measures the returns to capital per dollar of
using ratios. gross farm revenue. Recall, the two ways a
farm has of increasing profits is by
Three widely used financial increasing the profit per unit produced or by
ratios to measure solvency are the debt-to- increasing the volume of production while
asset ratio, the equity-to-asset ratio maintaining the per unit profit. The
(sometimes referred to as percent operating profit margin focuses on the per
ownership) and the debt-to-equity ratio unit produced component of earning profit
(sometimes referred to as the leverage ratio). and the asset turnover ratio (discussed
These three solvency ratios provide below) focuses on the volume of production
equivalent information, so the best choice is component of earning a profit.
strictly a matter of personal preference. The
debt-to-asset ratio expresses total farm Net farm income comes directly off
liabilities as a proportion of total farm of the income statement and is calculated by
assets. The higher the ratio, the greater the matching farm revenues with the expenses
risk exposure of the farm. The equity-to- incurred to create those revenues, plus the
asset ratio expresses the proportion of total gain or loss on the sale of farm capital
assets financed by the owner’s equity. The assets. Net farm income represents the
debt-to-equity ratio reflects the capital return to the farmer for unpaid operator and
structure of the farm and the extent to which family labor, management and owner’s
farm debt capital is being combined with equity. Like working capital, net farm
farm equity capital. It is a measure of the income is an absolute dollar amount and not
degree to which a farmer is leveraging his a ratio, thus comparisons to other farms is
equity. difficult because of farm size differences.

Profitability measures the extent to Repayment capacity measures the


which a business generates a profit from the ability to repay debt from both farm and
factors of production: labor, management non-farm income. It evaluates the capacity
and capital. Profitability analysis focuses on of the business to service additional debt or
the relationship between revenues and to invest in additional capital after meeting
expenses and on the level of profits relative all other cash commitments. Measures of
to the size of investment in the business. repayment capacity are developed around an
accrual net income figure.
Four useful measures of farm
profitability are the rate of return on farm The short-term ability to generate a
assets (ROA), the rate of return on farm positive cash flow margin does not
equity (ROE), operating profit margin and guarantee long-term survivability. Long-
net farm income. The ROA measures the term survivability requires the farm to be
return to all farm assets and is often used as profitable. The only way for an unprofitable
an overall index of profitability, and the farm to survive long-term is for income
higher the value, the more profitable the infusions from non-farm sources to offset
farm business. The ROE measures the rate farm losses. These cash infusions usually
of return on the owner’s equity employed in come from off-farm employment,

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inheritances and gifts or from a lender if the farm income from operations ratio. The
farm assets appreciate faster than the farm is asset turnover ratio measures how
losing money and the farmer can efficiently farm assets are being used to
successfully refinance the farm’s debts. generate revenue. The higher the ratio, the
more efficiently assets are being used to
Two measures of repayment capacity generate revenue.
are the term debt and capital lease coverage
ratio and the capital replacement and term The last four efficiency
debt repayment margin. The term debt and measures are operating ratios accounting for
capital lease coverage ratio provides a the composition of gross farm revenues.
measure of the ability of a borrower to cover The sum of the operating expense ratio,
all required term debt and capital lease depreciation expense ratio and interest
payments. The higher the ratio is over 1:1, expense ratio reflects the total direct farm
the greater the margin to cover the expenses per dollar of gross farm revenue
payments. Higher ratio values also indicate for each component—operating, interest and
greater flexibility on the part of the farmer to depreciation. Note that the operating
withstand and adjust to temporary adverse expense ratio standards will vary between
economic conditions. Even though the farm types of farms and operating systems.
may be generating sufficient accrual Taken together, these four ratios represent
earnings to cover all term debt and capital the total composition of gross revenues and
lease payments, there may not be sufficient in percentage terms accounts for 100 percent
cash to make the payments on a timely of the farms’ gross revenues.
basis; thus cash flow analysis is needed as
well. Available Capital and Capacity to
Attract Capital
The capital replacement and Farm businesses need capital
term debt repayment margin is used to to operate, to enter into new ventures or to
evaluate the ability of the borrower to expand the farm. A properly prepared
generate funds needed to service existing balance sheet reports the amount of cash and
term debts and replace capital assets. It also other liquid assets available to meet cash
enables users to evaluate the ability to needs. However, most farms have access to
acquire additional capital, service additional more cash than what they currently possess
term debt and to evaluate the risk margin. or realize. Nearly all farm businesses can
borrow additional cash and the capacity to
Financial efficiency measures the borrow (often called a credit reserve) is an
degree of efficiency in using labor, asset. Similarly, the ability to attract
management and capital. Efficiency investors is an asset that deserves to be
analysis deals with the relationships between recognized. The capacity to acquire
inputs and outputs. Because inputs can be additional cash allows a farm business to
measured in both physical and financial undertake new or expanded activities.
terms, a large number of efficiency
measures in addition to financial measures Assessing a farmer’s ability
are usually possible. to attract additional capital may be difficult
without someone who is willing to lend or
Five measures of financial invest. The financial ratios, and how they
efficiency are the asset turnover ratio, compare to similar farms, provide some
operating expense ratio, depreciation indication of the business' credit reserve.
expense ratio, interest expense ratio and net Likewise, a visit with a lender may offer

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insight into the size of a farm's credit losses resulting from reduction in yields or
reserve. price. The second link is the working
capital of the farm business. This indicates
Implicit in this consideration if the business has sufficient cash flow (and
is the cost of capital, that is, the rate of current assets) to cover operating losses that
interest the business must pay a lender or the occur in the first link. The third link is
return that must be paid to an investor. The current debt repayment capacity, which
higher the interest or dividend rate, the less shows the farm's ability to rely on a
capacity the farm has to acquire additional carryover operating loan to finance
capital; thus, the market interest rate directly operating losses. The fourth link is owner's
influences a farmer's credit reserve. equity, which is the business' ability to sell
assets to restructure its finances. The last
Capacity to Assume Risk link is collateral, which is the legal right to
The opportunity for any business to earn the owner's equity.
a profit requires assuming some risk.
Although not described as a business asset, Summary
the ability and willingness to assume risk is Financial measures are intended to help
critical. Types of risk a farm business’s farmers analyze their farm activities from a
encounter include production, marketing, financial standpoint and provide useful
financial, legal and human resource. A farm information needed to make good
likely will differ in its capacity to assume management decisions. By themselves, the
each type of risk exposure. financial measures discussed don’t provide
answers—they need to be reviewed in
Ability (or capacity) to assume risk relation to each other and to other farm and
differs from a willingness to assume risk, but non-farm activities. It is not possible to
either one can limit the risk exposure a firm control or predict all of the factors that
accepts. Farmers who recognize and influence the final outcome of any farm
prudently use their capacity to assume risk decision. Nor is it possible to have available
are likely to enhance their chance for all of the information that would be ideal.
financial success. But decision making can be improved
through using available information and
One way to consider a farm's capacity to through effective financial planning and
assume risk is to describe it as a chain with analysis.
five links. The first link is net earnings as a
percent of the value of the farm production,
which shows the farm's capacity to absorb

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“Sweet 16” Farm Financial Measures

Liquidity
1. Current ratio = total current farm assets/total current farm liabilities
2. Working capital = total current farm assets - total current farm liabilities

Solvency
3. Debt/asset ratio = total farm liabilities/total farm assets
4. Equity/asset ratio = total farm equity/total farm assets
5. Debt/equity ratio = total farm liabilities/total farm equity

Profitability
6. Rate of return on farm assets = (net farm income from operations + farm interest
expense - value of operator and unpaid family labor)/average total farm assets
7. Rate of return on farm equity = (net farm income from operations - value of operator
and unpaid family labor)/average total farm equity
8. Operating profit margin = (net farm income from operations + farm interest expense -
value of operator and unpaid family labor)/gross revenue
9. Net farm income

Repayment Capacity
10. Term Debt and Capital Lease Coverage Ratio = (net farm income from operations +
total non-farm income + depreciation expense + interest on term debt and capital leases
- total income tax expense - family living withdrawal)/principal and interest payments on
term debt and capital leases
11. Capital replacement and term debt repayment margin = net farm income from
operations + total non-farm income + depreciation expense - total income tax expense -
family living withdrawal (including total annual payments on personal liabilities) -
payment on prior unpaid operating debt - principal payments on current portion of term
debt and capital leases

Financial Efficiency
12. Asset turnover ratio = gross revenue/average total farm assets
13. Operating expense ratio = operating expense/gross revenue
14. Depreciation expense ratio = depreciation expense/gross revenue
15. Interest expense ratio = interest expense/gross revenue
16. Net farm income from operations ratio = net farm income from operations/gross
revenue