Three issues arise when it comes to money: economics, finance and taxes. In economics, we ask "Is it profitable?" Economics involves the application of the three secrets: reducing overheads, improving gross margin/unit and increasing turnover. In finance, we ask "How do I pay for it? How does the cash flow?"
If economics is our business's engine, finance is the gas that makes it go. We can have the engine in perfect working order, but if we are short of fuel (cash) we won't go very far.
For some operators, just knowing their numbers is a big step; it's a quantum leap to know what the numbers mean. Just as a doctor checks your temperature, pulse and blood pressure to evaluate your health, lenders use financial ratios calculated from information in your balance sheet to determine the financial health of your business.
The following ratios can help you check your business's vital signs. I've included a brief description of what each ratio indicates and a generally accepted benchmark for each ratio. However, there are no hard and fast rules. Safe benchmarks for your business depend on:
1. How accurately the assets have been valued;
2. How much risk is inherent in the business;
3. The economic outlook for your business (where are we in the cattle cycle?);
4. Attitude about risk (both yours and your lender's).
Economic Benchmarks - Knowing the economic condition of the business is a prerequisite to checking the financial status. Return on equity (ROE) is an economic benchmark that shows the profit produced by the owner's investment in the business.
Dividing profit by equity (net worth) is how ROE is calculated (profit divided by equity = ROE). We've been using a ROE benchmark of 10% (> 0.10) at the Ranching for Profit School.
The inventory turnover ratio (ITR) indicates the economic efficiency of production. It's calculated by dividing the gross margin by the inventory valuation of livestock (gross margin divided by inventory valuation = ITR).
The gross margin is calculated by subtracting all direct costs (feed, health, trucking, marketing expenses and interest on livestock) from gross product (liv estock sales minus livestock purchases, plus changes in the value of livestock inventory). A ratio below 30% (< 0.3) indicates that the economic efficiency of production is poor.
Financial Benchmarks - Liquidity ratios and solvency ratios are the two basic kinds of financial ratios.
Liquidity ratios (also called current ratios) measure the business's ability to meet its current obligations. They show the relationship between current liabilities and current assets.
Current liabilities are things that have to be paid within the next 12 months. Current assets include cash and things that can be readily converted into cash - like accounts receivable, livestock and crops intended for sale, as well as feed, fuel and fertilizer that will be converted into things we mean to sell.
Many lenders use current ratios to evaluate liquidity. However, because income on most farms and ranches is seasonal, the current ratio can vary a lot from month to month. It therefore may not tell you much about the ability of the business to pay its bills. A good cash flow budget, updated monthly to show the actual expenditures, is a better test of liquidity for most agricultural businesses.
Solvency ratios are used to evaluate the financial structure of the business. They show the degree to which a business is leveraged and indicate the business's ability to withstand risk and remain solvent.
The greater the percentage of borrowed capital (leverage), the greater the return, as long as the business is profitable. But, when the business suffers a loss, a highly leveraged business is in big trouble.
The net capital ratio (NCR) measures the overall solvency of a business. It's calculated by dividing total assets of a business by its total liabilities (total assets divided by total liabilities = net capital ratio). The NCR of a healthy business generally exceeds 2:1 (> 2).
Some debt may be prudent, but too much is dangerous. The debt-to-equity ratio (DER) shows the extent to which a business is leveraged. It's used as a measure of the financial risk carried by a borrower. DER is calculated by dividing total debt by the equity or net worth (total debt divided by total equity = DER). A DER of less than 1:2 (< 0.5) is usually considered safe.
These ratios are not cast in stone. Missing the benchmark for one or more of them does not necessarily spell doom. However, it should raise a red flag regarding the financial health of your business and help determine if you are ranching for profit.
David Pratt of Ranch Management Consultants teaches the Ranching for Profit School. For more information visit www.ranchmanagement.com, or contact him at 707/429-2292 or e-mail: [email protected]