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

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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.

Key Financial Indicators Measures of liquidity  See equations 1 and 2; page 13 of booklet Measures of solvency  See equations 3 – 6; page 14 Measures of profitability  See equations 7 – 8; page 15 Measures of economic efficiency  See equations 10 – 14; pages Measures of debt repayment capacity  See equations 15 – 17; page 17

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 Page 13

Liquidity Trends Survived Failed Minimum Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research Page 13

Liquidity Trends Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research Desired level varies by type of firm Page 14

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 Page 15

Solvency Trends Survived Failed Maximum Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research Page 15

Measures of Profitability Rate of return on assets 1. Rate of return on assets: Net farm income before interest divided by total assets. Demonstrates the return to management and 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 farm income before interest divided by total assets. Demonstrates the return to management and 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 farm income divided by total equity. Demonstrates return to owner’s investment 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 Page 16

Profitability Trends Survived Failed Minimum Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research Page 16

Measure of Debt Repayment Capacity Term Debt and Capital Lease Coverage Ratio 1. Term Debt and Capital Lease Coverage Ratio: Net cash income 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.

Measure of Debt Repayment Capacity Term Debt and Capital Lease Coverage Ratio 1. Term Debt and Capital Lease Coverage Ratio: Net cash income 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. Debt burden ratio 2. Debt burden ratio: Total liabilities divided by net income After provision for taxes and depreciation Should be as low as possible to avoid financial risk exposure

Debt Repayment Capacity Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research Desired level varies by type of firm Page 18

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

Sample Question Is this firm liquid, solvent, profitable and can it cover its term debt and capital lease payments? Same firm level data used in Slide Show #1

Step #1 Calculate the following Step #1 Calculate the following: 1. Current assets and total assets 2. Current liabilities and total liabilities 3. Net income 4. Equity (or net worth) Total current assets = 10, , ,000 = 43,000 Total current liabilities = 1, , ,213 = 15,913 Total assets = total current assets + 76, , ,500 = 233,000 Total liabilities = total current liabilities + 29, ,200 = 46,613 Equity = 233,000 – 46,613 = 186,387 Cash receipts from product sales = 73,000 Total operating expenses = 51, , ,400 = 61,100 Net income from operations = 73,000 – 61,100 = 11,900 Net income before taxes = 11,900 Net income = 11,900 – 7,213 = 4,687 Sample Question

Step #2 Calculate the following Step #2 Calculate the following: 1. Current ratio 2. Debt and leverage ratio Asset liquidity analysis Asset liquidity analysis: Total current assets = 10, , ,000 = 43,000 Total current liabilities = 1, , ,213 = 15,913 Current ratio = 43,000/15,913 = Working capital = 43,000 – 15,913 = 27,087 Solvency analysis Solvency analysis: Total assets = total current assets + 76, , ,500 = 233,000 Total liabilities = total current liabilities + 29, ,200 = 46,613 Equity = 233,000 – 46,613 = 186,387 Debt ratio = 46,613/233,000 = 0.20 Leverage ratio = 46,613/186,387 = 0.25 Sample Question

Step #3 Calculate the following Step #3 Calculate the following: 3. ROA and ROE Total assets = 233,000 Equity = 186,387 Cash receipts from product sales = 73,000 Total operating expenses = 51, , ,400 = 61,100 Net income from operations = 73,000 – 61,100 = 11,900 Net income before taxes = 11,900 Net income = 11,900 – 7,213 = 4,687 Profitability analysis Profitability analysis: ROA = (4, ,500)/233,000 = or 3.1% ROE = 4,687/186,387 = or 2.5% Sample Question

Step #4 Calculate the following Step #4 Calculate the following: 4. Term debt and capital lease coverage ratio 5. Debt burden ratio Debt repayment capacity analysis Debt repayment capacity analysis: Net cash income = 4, ,400 = 12,087 Principal payments = 5,000 Coverage ratio = 12,087/5,000 = 2.42 Debt burden analysis Debt burden analysis: Net income = 4,687 Total liabilities = 46,613 Debt burden ratio = 46,613/4,687 = 9.95 Sample Question

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. Page 19

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? Page 19

Comparative Analysis Compare the firm’s current performance with the performance of similar operations like the Beaver study did. Benchmark analysis at enterprise level should be done whenever possible. Your firm Benchmark Page 20

Comparative Analysis Compare the firm’s current performance with the performance of similar operations like the Beaver study did. Benchmark analysis at enterprise level should be done whenever 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 Page 20

Pro Forma Analysis Stress testing Stress testing current expected cash flows by varying prices, unit costs and yields (Slide Show #3). 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

Any Questions?