Financial Check Up John B. Penson, Jr. Regents Professor and Stiles Professor of Agriculture Texas A&M University

Seen the Doc Lately? financial Benefits from an annual financial checkup. financial Treadmill stress test your financial strength. vision Get your vision examined.

What is the status of your…. Liquidity? Solvency? Profitability? Efficiency? Debt repayment capacity? Survivability?

Key Financial Indicators Sweet 16 Financial Indicators Farm Financial Standards Council Focus today on a few key indicators of liquidity, solvency, profitability, financial efficiency, debt repayment capacity and the implications for survivability.

Measures of Liquidity Current ratio 1. Current ratio: Current assets divided by current liabilities. Demonstrates ability to cover scheduled current liabilities for the coming year out current assets and still have “cash” left over. exceed 1.0 Should exceed 1.0 to be technically liquid. Some firms fail despite exceeding this hurdle.

Measures of Liquidity Current ratio 1. Current ratio: Current assets divided by current liabilities. Demonstrates ability to cover scheduled current liabilities for the coming year out current assets and still have “cash” left over. exceed 1.0 Should exceed 1.0 to be technically liquid. Some firms fail despite exceeding this hurdle. Working capital 2. Working capital: Current assets minus current liabilities. Expresses liquidity in dollars rather than ratio. Should be positive. Cash is King!

Liquidity Trends Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity Trends Survived Failed Minimum Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity Trends Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measures of Solvency Debt ratio 1. Debt ratio: Total debt divided by total liabilities. Demonstrates ability to liquidate the firm, cover all liabilities out of all assets, and still have “cash” left over. not exceed 0.50 Should not exceed 0.50 to minimize financial risk exposure. Some firms fail however at lower levels.

Measures of Solvency Debt ratio 1. Debt ratio: Total debt divided by total liabilities. Demonstrates ability to liquidate the firm, cover all liabilities out of all assets, and still have “cash” left over. not exceed 0.50 Should not exceed 0.50 to minimize financial risk exposure. Some firms fail however at lower levels. Leverage ratio 2. Leverage ratio: Total debt divided by equity or net worth. Often a credit standard in loan approval decisions. not exceed 1.0 Should not exceed 1.0 to minimize financial risk exposure. Effects of rising interest rates.

Solvency Trends Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Solvency Trends Survived Failed Maximum Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measures of Profitability Rate of return on assets 1. Rate of return on assets: Net farm income before interest and taxes divided by average farm assets during the year. Demonstrates the accrual adjusted pre-tax return to management total capital invested in the farm operation. positive Should be positive; the higher the better.

Measures of Profitability Rate of return on assets 1. Rate of return on assets: Net farm income before interest and taxes divided by average farm assets during the year. Demonstrates the accrual adjusted pre-tax return to management total capital invested in the farm operation. positive Should be positive; the higher the better. Operating profit margin ratio 2. Operating profit margin ratio: Net farm income before interest and taxes divided by gross farm revenue. Demonstrates accrual adjusted income per dollar of goods sold percent range Typically in the percent range.

Profitability Trends Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Profitability Trends Survived Failed Minimum Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measure of Debt Repayment Capacity Term Debt and Capital Lease Coverage Ratio 1. Term Debt and Capital Lease Coverage Ratio: Funds available from operations to cover scheduled payments divided by scheduled principal payments on term loans and capital leases. After provision for taxes and withdrawals. greater than 1.0 Should be greater than 1.0. Non-farm income often factored in by lenders.

Measure of Debt Repayment Capacity Term Debt and Capital Lease Coverage Ratio 1. Term Debt and Capital Lease Coverage Ratio: Funds available from operations to cover scheduled payments divided by scheduled principal payments on term loans and capital leases. After provision for taxes and withdrawals. greater than 1.0 Should be greater than 1.0. Non-farm income often factored in by lenders. Capital Replacement and Term Debt Margin 2. Capital Replacement and Term Debt Margin: Funds available from operations to cover scheduled payments and replace aging equipment and buildings. After provision for taxes and withdrawals. positive Should be positive; the higher the better.

Debt Repayment Capacity Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Some Conclusions…. Indicators of growth/survival: Indicators of growth/survival: Increasing liquidity Increasing solvency Increasing debt repayment capacity Increasing profitability Indicators of potential failure: Indicators of potential failure: Declining liquidity Declining solvency Decreasing debt repayment capacity Decreasing profitability

Tale of Two Cities… Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Tale of Two Cities… Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Tale of Two Cities… Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Tale of Two Cities… Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Multiple Uses of Financial Indicators

Historical Analysis A look backwards like the Beaver study. Comparison of current performance with past performance. Recommend doing this at the enterprise level as well as for the farm as a whole.

Historical Analysis A look backwards like the Beaver study. Comparison of current performance with past performance. Recommend doing this at the enterprise level as well as for the farm as a whole. declines in last two years? Reasons underlying unwanted trends such as the declines in last two years?

Comparative Analysis Comparing current performance with similar operations like the Beaver study. Benchmark analysis at enterprise level when possible. Your firm Benchmark

Comparative Analysis Comparing current performance with similar operations like the Beaver study. Benchmark analysis at enterprise level when possible. before it is too late Address reasons why your firm is performing more poorly than other comparable operations before it is too late. Your firm Benchmark

Pro Forma Analysis Stress testing Stress testing current expected cash flows by varying prices, unit costs and yields. future financial health Look at implications of longer run price and unit cost trends on future financial health when making major decisions.

Forces of change…. Impacts of rising unit costs of production inputs. Prices, costs and yields can all affect the financial health of the firm. Failure to account for the risk associated with adverse trends can lead to failure of the firm.

Sources of Uncertainty Global trends in production and consumption Energy prices and core inflation trends Interest rates and exchange rates WTO and the 2007 farm bill

Reading the Road Signs in Financial Statements

Some Signs Are Confusing…

Signs to Avoid…

Some signs were hard to read in the 1980s...

What we saw when things became clear in the 1980’s

Ignoring adverse trends has its consequences….

Any Questions?