Balance Sheet Ratios Roger Betz, Sherrill Nott and Gerald Schwab Day 2 1:00 p.m. to 1:30 p.m.

Ratios Defined: One number divided by another to express a relationship You already know ratios like –Tons hay per acre –Bu. corn per acre –Pigs per litter –Milk sold per cow, etc. The above illustrates production ratios

Ratios Be Selective Now is the time to become familiar with financial ratios Select ratios that help focus attention on the most critical areas. Ratio analysis can be done on –Historical –Current –Projected information

Balance Sheet Discussion questions Judgments are made based on balance sheets. What is a “good” balance sheet? What is a “good” financial situation?

Balance Sheet Analysis To remember... Basic equations  Assets = Debt + Equity  Assets minus debts = equity  Assets - equity = debt

Balance Sheet Ratio Analysis FINPACK Balance Sheet (Schedule W) Will now define the ratios FINPACK prints out (must be important!) Your balance sheet may or may not have a number for all the ratios discussed.

Balance Sheet Ratios Schedule W from Finpack 99 Note both Cost and Market value columns

Current Ratio = Do I have enough current assets to cover current liabilities? –Current portion of term debts included Current portion of income taxes often forgotten Static in nature, no timing of cash flows Ignores lines of credit available Total Current Farm Assets Total Current Farm Liabilities

Current Ratio = 12 month planning horizon Value of current assets may change when sold Desired level varies by type of farm –Dairy versus fruit or cash crop Value can vary during production cycle Total Current Farm Assets Total Current Farm Liabilities

Farm Working Capital = Similar to Current Ratio, is dollar amount, not a percentage or ratio Difficult to compare to other farms Depends on size of business Total Current Farm Assets - Total Current Farm Liabilities

Current % in Debt Total Current Liabilities (divided by) Total Current Assets (times 100 for percentage) Shows current farm assets relative to current farm liabilities Similar % ratios: –Intermediate % in debt –Current & intermediate farm % in debt –Long term farm % in debt –Nonfarm % in debt

Current % in Debt Total Current Liabilities (divided by) Total Current Assets (times 100 for percentage) Measures amount of current farm assets relative to the level of current farm liabilities Measures the extent to which current farm assets, if sold, would be used to cover current farm debts January versus June? Timing!

Intermediate % in Debt Total Intermediate Liabilities (divided by) Total Intermediate Assets (times 100 for percentage) Measures the amount of intermediate farm assets relative to the level of intermediate farm liabilities What items make up the majority of intermediate assets? e. g. machinery, breeding livestock

Debt to Asset Ratio Total Farm Liabilities (divided by) Total Farm Assets What % of my business assets do I owe to creditors Measures financial position or solvency of the business Creditors claim against the business Measure risk exposure - “ability to take hits” –a higher ratio indicates higher risk, don’t hit Should include deferred taxes if using market value versus cost basis

Equity to Asset Ratio Total Farm Equity (divided by) Total Farm Assets Measures financial position of the business Owner’s claim against the business Ratios add to one: (Equity  Asset) + (Debt  Asset) = 1 % owner finance + % debt finance = total capital

Debt to Equity Ratio Total Farm Liabilities (divided by) Total Farm Equity Measures financial position of the business Ratio gets high rapidly as debt increases Also called Financial Leverage Ratio Lenders tend to use it

Can you define and use some other Balance Sheet ratios? What is the formula for: Current & intermediate farm % in debt? Long-term farm % in debt? Nonfarm % in debt?

Balance Sheet Ratio Analysis How to interpret? (for Mich. Dairy Farm) Dec. 31, 1999 CostMarket Current % in debt 3434 Intermediate % in debt 2516 Long-term % in debt 6228

Balance Sheet Ratios Finpack Balance Sheet Sch. W: be selective! Current Ratio –Lenders love it! –Understand how it can vary by month –2.0 or higher is nice % in debt: current, intermediate, long, terms –Borrow long-term to buy long-term-- i.e., match maturities –Look at trend over time

Debt to Asset Ratio –Lots of folks talk about it –At 0.5, you own half, lenders “own” half –0.70 and higher --- danger You own 30 % Earnings can’t meet debt service plus everything else

What’s Next? Examine the case study farm balance sheet Quality check and interpret your balance sheet.