Recently, an agricultural lender asked me some great questions, “What are the five key ratios producers need on their financial dashboard, and are there any emerging trends now that the economic cycle has changed?” Well, there is an old saying that financial ratios will identify symptoms but not the cause of the problem. However, producers who manage for profit and sustainability should use ratios to measure performance. Then, identify the source of any problems and proactively develop strategies for solutions.
First on everyone’s dashboard of key ratios, specifically if you are borrowing money, is term debt and lease coverage ratio; also called the debt coverage ratio. To calculate it, start with the amount of net income (farm and nonfarm) and add depreciation and interest paid, then subtract living expenses and income tax. Then, divide that subtotal by debt service (principal and interest). What is the trend over the years?
From historical analysis of FINBIN data, the top 20 percent of profitable producers carry a 200 percent debt coverage ratio or above. The bottom 20 percent generate a ratio under 100 percent. How does the bottom 20 percent stay in business? Well, it often entails refinancing of operating monies to term debt. This is not a sign of good health for the business. During the great commodity super cycle, the average producer’s levels were approximately 250 percent. In the last two years, post the great commodity super cycle, those levels dropped to an average of 170 percent. Thus, debt servicing ability is now hindered, specifically, in the grain sector.
One of my favorite ratios is the operating expense to revenue ratio. To derive this ratio, the operating expenses, excluding interest and depreciation, are divided by revenue. Historically, top level profitable managers generate a dollar’s worth of income for less than $0.65. In the recent years of 2013 and 2014, this has jumped to an average of $0.73 for top level producers due to suppressed commodity prices, higher cash rents and other expenses. The average producer in recent years requires approximately $0.80 to generate a dollar’s worth of income. Unfortunately, it is nearly dollar for dollar for the bottom 20 percent of producers. Now, that is margin compression!
Additionally, carefully watch your debt to asset ratio. Above 50 percent requires strong debt coverage ratios that are above 200 percent and an operating expense to revenue ratio under 70 percent. These would be good offsetting metrics to assist in handling the higher debt load.
The rate of return on assets using cost-based balance sheets is another good financial metric. Above 10 percent is usually achieved by the top 20 percent of managers. The bottom 20 percent usually have a negative rate of return on assets. Aspire to generate return on assets greater than the long-term rate of inflation and interest rates on borrowed money.
Finally, the working capital to revenue ratio is very useful. The top 20 percent of producers will usually maintain above 40 percent working capital to revenue ratio depending on the economic cycle. The bottom 20 percent will be under 10 percent. This metric is your financial shock absorber in case of periods of low profit and poor cash flow.
Hopefully, these financial observations will help you develop a dashboard specific for your business. Utilizing ratios is a good way to give your business a “checkup” to determine its level of health. Remember that while ratios are useful in measuring business performance, there may be a greater, underlying issue that requires attention. Ratios can easily identify something like a cash flow shortage, but only a good manager can recognize the problems causing the shortage and take corrective actions.