About this time of year you have made the transition from the combine and tractor seat to the computer seat. Your family has heard a lot of crunching lately, and it has been numbers and not potato chips. While you get your taxes and finances in order, you might satisfy your curiosity a bit to see how you are “really” doing. Yes, you have money in the checking account, but there are some equity changes and debt changes, and you are not sure whether or not to feel good about your financial position. As your tax advisor and lender would say, “Let’s take a look at your numbers.”
For years you have been filling out all of the forms offered by FAST Tools, but at the end of the day, you wonder if your working capital, liquidity and all of those other ratios are where they should be. Financial specialists Gary Hachfeld, David Bau, and Robert Holcomb in the University of Minnesota Center for Farm Financial Management have published a new series of financial fact sheets, but the #5 in the series helps you get a good grip on your financial reality.
Your liquidity indicates whether the operation has the ability to generate a sufficient cash flow to pay your debts, your taxes, and feed your family. There are several different yardsticks that are combined to give you a good picture of your liquidity, should your lender happen to ask early next year.
1) Current farm assets include your cash and anything that can be converted to cash within the next 12 months.
2) Current liabilities are your bills that need to be paid within the next 12 months.
If you divide the current assets by the current liabilities, you have a “current ratio” that show for every so many dollars of debt you have so many dollars of assets. If it is more than 1.7, it is strong, but if you are below 1.1, your bank loan file will have a red flag on it.
Another indicator of liquidity is working capital, in which your current liabilities are subtracted from your current assets. The larger the number the better, and bigger operations should have bigger numbers for working capital. It indicates your potential for paying taxes, college tuition, nursing home fees, and Friday night movie tickets. The Minnesota economists say just because you are short on working capital, does not mean you are not wealthy, but it may mean your liquidity is on the “dry” side. They also add that a certain amount of working capital may be totally insufficient for one farm, and way more than sufficient for another farm.
So how do you improve your liquidity by making adjustments? Buying and selling assets and refinancing, can make a number of changes. But before you begin playing Monopoly with your farm, consult your financial advisors, determine what you need to do, and take some time to make those adjustments.
Another yardstick with liquidity is solvency. That is the ability to pay off any and all of your debts and have money left over. Solvency is determined by a series of three ratios, comparing your assets, your equity, and your debts. By teaming up two of the three you get a glimpse of your solvency. Each of the ratios will be a percentage, and the size of the percentage will indicate whether you are doing well or not so well.
1) A debt to asset ratio of 35% means you have 35 cents of debt for each $1 of assets. Lower is better.
2) An equity to asset ratio of 65% means you really own 65 cents of every $1 worth of asset you control. Higher is better, since it reveals your net worth. The Minnesota economists remind you that every asset is either owned by you and/or a lender, so those two ratios will equal 100% when added together.
3) A debt to equity ratio shows how your equity is leveraged by how much debt your have. In this example, divide 35% by 65% to find that for every $1 of net worth you have 54 cents of debt.
The ratios are good to calculate annually, not just to satisfy your curiosity, but to show any trends that are developing. Your lender is watching that trend, and if you spot it before he or she mentions it, and offer a solution to reverse a concerning trend, you will score higher on the loan renewal.
Financial ratios can reveal many good and bad trends in a farming operation, and managing those trends will increase the stability of the operation. Liquidity and solvency are just two of many, and each of those has ratios within them. Operators want to manage the ratios with a variety of actions that can be taken during the year.
Source: FarmGate blog