Financial Check Up Agribusiness Finance LESE 306 Fall 2009

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 Generally accepted Financial Indicators 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 assets. 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 assets. 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 income plus interest divided by total assets. Demonstrates the after-tax return to the total capital invested in the firm. positive Should be positive; the higher the better.

Measures of Profitability Rate of return on assets 1. Rate of return on assets: Net income plus interest divided by total assets. Demonstrates the after-tax return to the total capital invested in the firm. positive Should be positive; the higher the better. Rate of return on equity 2. Rate of return on equity: Net income divided equity. Demonstrates the after-tax return on owner equity invested in the firm. positive Should be positive; the higher the better.

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: Cash available from operations to cover scheduled payments (net income plus depreciation and interest payments less withdrawals) divided by scheduled principal and interest 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: Cash available from operations to cover scheduled payments (net income plus depreciation and interest payments less withdrawals) divided by scheduled principal and interest 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. Debt Burden Ratio 2. Debt Burden Ratio: Total debt outstanding divided by net income. Number of years required to retire total debt if net income remains constant and used entirely for this purpose low Should be low; the lower the better.

Debt Repayment Capacity Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research Inverse of debt burden ratio assuming use of depreciation allowances to retire debt.

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

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

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

#1: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.

#1: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. Why is ROA falling? Why is ROA falling?

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

#2: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

#2: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.

#2: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.

#2: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.

#2: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.

#3: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.

Sources of Uncertainty Global trends in production and consumption Energy prices and core inflation trends Interest rates and exchange rates Changes in industry subsidies

Reading the Road Signs in Financial Management

Pro Forma Analysis When going down the road, use the windshield as well as the rear view mirror!

Some Signs Are Confusing…

Some Signs are Hard to Read...

Ignoring Adverse Trends has its Consequences….