financial statement analysis...analyzing financial position and performance • techniques for...

Financial Statement Analysis Understanding and Using Financial Ratios

Introduction • The four financial statements contain much of the

information need to make business decisions • How can this information be used to analyze a farm

or a business? • Decision making can be improved through financial

planning in five ways ▫ Identify and learn from past mistakes ▫ Make fewer mistakes ▫ Take timely and appropriate action to correct mistakes

that are made ▫ Identify strengths and weaknesses ▫ Spot opportunities

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Financial Management in Agriculture

9/13/2013

Analyzing Financial Position and Performance • Techniques For Analysis ▫ Financial Statements Trends Cost vs. Market Asset vs. Debt Structure Cash vs. Accrual

▫ Pro Forma Analysis What if Commodity and Weather Cycles Breakeven

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Analyzing Financial Position and Performance ▫ Monitoring and Control Projected vs. Actual Variance Analysis Operations and plan adjustments

▫ Ratio Analysis Standards – Ranges Trend (direction and slope) Historical variability Projected vs. Historical Average Sensitivity Analysis Interrelationships (DuPont Model)

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Ratio Analysis • Three standards of comparison for ratios ▫ Compare the business against itself Past performance to present Present performance to budgeted performance Able to identify trends

▫ Compare the business to a set of benchmarks Benchmarks must be first determined (e.g. Peer

Groups) ▫ Compare the business to an average or quartiles

for firms of similar size and type Regional databases, ag lenders, ag accounting firms

9/13/2013 Financial Management in Agriculture

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Notes of Caution • Apples to Apples ▫ Income calculation Before or after tax Cash or accrual Business only or combination of business and personal

▫ Business organization form ▫ Balance Sheet Cost basis valuation or market based Business only or combination of business and personal Deferred taxes included or not


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Financial Measures

• Five criteria ▫ Liquidity ▫ Solvency ▫ Profitability ▫ Repayment capacity ▫ Financial efficiency

• All measure financial position or financial performance


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Liquidity Measures • Liquidity ratios ▫ Measures the ability of the farm business to meet

financial obligations as they come due, without disrupting the normal, ongoing operations of the business

• Analyzed two ways ▫ Structural liquidity Balance sheet measures Relationship between assets and liabilities

▫ Operational liquidity Cash flow measures


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Liquidity Measures

• Working Capital ▫ Measure of the amount of funds that would be

available to purchase inputs after the sale of current farm assets and payment of all current farm liabilities

• Equation ▫ Working Capital = Total Current Farm Assets –

Total Current Farm Liabilities


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Issues of Working Capital

• Absolute dollar amount ▫ Difficult to make comparisons between businesses ▫ Unable to establish one standard ▫ Dependent upon size of firm

• Future projections ▫ Reflects amount at one point in time ▫ Does not reflect timing of future cash flows


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Current Ratio

• Used to evaluate the relationship between total current farm assets and total current farm liabilities

• Equation ▫ Total Current Farm Assets/Total Current Farm

Liabilities


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Current Ratio

• Relative measure • Higher the ratio, the more liquid the business • Acceptable values vary with business type • Not dependent on size of firm, can be used for

comparisons


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Working Capital to Gross Revenues

• FFSC found it to be more useful than the current ratio

• Equation ▫ Working Capital/Gross Farm Income

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Cash Flow Coverage Ratio

• Assesses the business’s ability to meet cash obligations

• Calculated from the cash flow statement • Equation ▫ Total Cash Available/Total Cash Required


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Cash Flow Coverage Ratio

• The higher the ratio, the higher the liquidity • Can be used for scenario analysis


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Budgeting Error

• Equation ▫ [(Actual Total Cash Available – Actual Total Cash

Required) – (Projected Total Cash Available – Projected Total Cash Required)] ÷ (Projected Total Cash Available – Projected Total Cash Required) X 100

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Solvency

• Measures the amount of borrowed capital or debt, leasing commitments and other expense obligations relative to the amount of owner’s equity invested in the business.

• Solvency measures provide an indication of the firm’s ability to repay all financial obligations if all assets were sold, and an indication of the ability to continue operations as a viable business after a financial adversity.

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Solvency Measures • Concerned with long-term as well as short-term

assets and liabilities • Evaluates what would happen if all assets were sold

and converted to cash and all liabilities were paid • Indicates the business’s ability to withstand risks

and to continue operations after financial adversity • The most straightforward measure ▫ Owner equity Difficult to measure Depends on size of firm


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Solvency Measures

• Debt to Asset • Debt to Equity • Equity to Asset • All three are equivalent because they use 2 of the

3 parts of the balance sheet identity equation, TA = TL + OE. If you know any two of the variables, you can determine the third.


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Debt to Asset Ratio

• Expresses total farm liabilities as a proportion of total farm assets

• One way to express financial risk exposure • If the ratio is more than .5:1 the creditors have

more money in the business than the owners • Equation ▫ Total Farm Liabilities/Total Farm Assets


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Debt to Asset Ratio

• Three main issues ▫ Greatly influenced by the value placed on farm

assets Market based Cost based

▫ Impact of deferred taxes ▫ Reasonable standard will vary from one type of

enterprise to another No single standard Depends on how debt is being used


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Debt to Equity Ratio

• Reflects the extent to which farm debt is being combined with farm equity capital

• Often called the leverage ratio, but all the solvency measures are measures of leverage

• If the ratio is less than 1:1 the creditors have less money in the business than the owner

• Equation ▫ Total Farm Liabilities/Total Farm Equity


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Equity to Asset Ratio

• Expresses the proportion of total assets financed by the owner’s equity capital

• Also called percent ownership • Mirror image of debt to asset ratio • If the ratio is more than .5:1 the owners have

more money in the business than the creditors • Equation

Total Farm Equity/Total Farm Assets


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Profitability Measures • Measures the extent to which a business generates

profit from the use of labor, management, and capital

• Relationship between revenues and expenses • Net Farm Income ▫ Represents the returns to the farm for unpaid operator

and family labor, management and owner’s equity. ▫ Absolute dollar amount Difficult to make comparisons Before tax amount Organizational form


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Return on Farm Assets (ROA)

• Used an overall index of profitability • Most meaningful for comparisons • Equation ▫ (Net Farm Income From Operations + Farm

Interest Expenses – Family Living Withdrawals) / Average Total Farm Assets


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ROA Issues

• Family withdrawals • Realized and unrealized capital gains are not

included ▫ May distort the ratio

• Method of valuation • Pre-tax basis • Non-farm assets should be excluded


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Rate of Return on Farm Equity (ROE)

• Measures the rate of return on the owner’s equity in the farm business ▫ Differs from ROA because ROA considers both

owned and borrowed capital • Equation ▫ (Net Farm Income From Operations – Family

Living Withdrawals) / Average Farm Equity


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ROE Issues

• Same as ROA • Higher the ratio, the more profitable the

business • If ROE is less than ROA (ROE/ROA is called the

power ratio) ▫ Business is paying more interest on borrowed

money than is being earned


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Operating Profit Margin Ratio

• Measures the returns to capital per dollar of gross revenue

• Two ways to increase profit ▫ Increase profit per unit produced ▫ Increasing the volume of production ▫ This ratio is concerned with the first

• Equation ▫ (Net Farm Income From Operations + Farm

Interest Expense) / Gross Farm Income


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EBITDA

• Equation ▫ Net Farm Income (pre-tax) + Farm Interest

Expense + Depreciation & Amortization

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Repayment Capacity

• Measures the ability to repay debt from both farm and non-farm income

• Evaluates the capacity of the business to service additional debt


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Capital Debt Repayment Capacity

• Equation ▫ Net Farm Income + Depreciation + Net Non-Farm

Income + Interest on Term Loans – Family Living Withdrawals & Income Taxes

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Capital Debt Repayment Margin

• Equation ▫ Capital Debt Repayment Capacity – Scheduled

Principal & Interest on Term Loans (includes payments on capital leases)

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Debt to Income Ratio

• Measures the amount by which total debt exceeds annual income

• Recognizes that equity is not the only thing a borrower can leverage

• Useful for tracking the overall financial health of the farm sector.

• Equation ▫ Total Farm Liabilities/Net Farm Income


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Term-Debt Coverage Ratio

• Equation ▫ Capital Debt Repayment Capacity/Scheduled

Principal & Interest on Term Loans (includes payments on capital leases)

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Financial Efficiency Measures

• Measures the intensity with which a business uses its assets to generate gross revenues and the effectiveness of production, purchasing, pricing, and financing, and marketing decisions.


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Equations • Asset Turnover Rate ▫ Gross Farm Income/Average Total Farm Assets ▫ Operating Profit Margin X Asset Turnover = ROA

• Operating Expense Ratio ▫ (Total Farm Operating Expenses – Farm Interest &

Depreciation) / Gross Farm Income • Depreciation Expense Ratio ▫ Depreciation/Gross Farm Income

• Interest Expense Ratio ▫ Farm Interest Expense/Gross Farm Income

• Net Farm Income From Operations Ratio ▫ Net Farm Income From Operations/Gross Farm Income

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Other Measures

• Average Collection Period ▫ Accounts Receivable / (Annual Credit Sales ÷ 360)

• Average Days Payable ▫ Accounts Payable / (Annual Credit Purchases ÷

360) • Days Inventory ▫ Inventory/(Annual Cost of Goods Sold ÷ 360)

• Inventory Turnover ▫ Gross Sales/Average Inventory

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Other Measures

• Labor Productivity ▫ (Labor & Salary Expenses + Family Living

Withdrawals) / Gross Farm Income ▫ (Labor & Salary Expenses + Family Living

Withdrawals) / Total Tillable Acres • Machinery & Equipment Productivity ▫ Machine & Equipment Expenses (including

depreciation) / Gross Farm Income ▫ Machinery & Equipment Expenses (including

depreciation) / Total Tillable Acres

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9/17/2013

DuPont Analysis

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9/17/2013

ROE = [ ROA - Interest Assets

[ Assets Equity

ROE = [

[ Income Gross Revenue

Assets Equity Assets

Gross Revenue Interest Assets -

Profit Margin

Asset Turnover

Interest Cost

Leverage

DuPont Model

Current Liab.

+

Long-term Liab.

Total Assets

Total Liab.

less

Total Assets

Net Worth

Divided by Financial Leverage

Sales

COGS

Gross Profit

Operating Expense

Expense Percent

Gross Margin

less

less Operating Profit

less Federal Taxes

After-tax Profit

Sales

Divided by Net Profit Margin

Inventory Turnover

Age of Accts. Rec.

Inventory

Accts Receivable

+

+

Cash

Current Assets

+

Fixed Assets

Total Assets

Divided by

Sales

Asset Turnover

Return on Assets

X

Return on Equity

X


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DuPont Model Base

Current Liab. $69,406

+ Long-term

Liab. $266,970

Total Assets

$1,535,303

Total Liab.

$336,376

less

Total Assets

$1,535,303

Net Worth

$1,198,927


1.28

Sales $1,345,803

COGS $878,633

Gross Profit $467,170

Operating Expense

$392,924

Expense Percent

29%

Gross Margin

35%

less

less Operating

Profit $74,246

less Federal Taxes

$0

After-tax Profit $74,246

Sales $1,345,803

Divided by Net Profit

Margin 5.52%

Inventory Turnover

1.61

Age of Accts. Rec.

55

Inventory $833,393

Accts Receivable

$202,085

+

+

Cash $35,502

Current Assets

$1,070,980

+ Fixed Assets $464,323

Total Assets

$1,535,303

Divided by

Sales $1,345,803

Asset Turnover

0.88

Return on Assets

4.84%

X

Return on Equity

6.19%

X


42

Increase Gross Margin by 2%


+ Long-term

Liab. $266,970

Total Assets

$1,535,303

Total Liab.

$336,376

less

Total Assets

$1,535,303

Net Worth

$1,198,927


1.28

Sales $1,345,803

COGS $878,633


Operating Expense

$392,924

Expense Percent

29%

Gross Margin

37%

less

less Operating

Profit $105,021

less Federal Taxes

$0


Sales $1,345,803


Margin 7.80%

Inventory Turnover

1.61

Age of Accts. Rec.

55

Inventory $833,393

Accts Receivable

$202,085

+

+

Cash $35,502

Current Assets

$1,070,980


Total Assets

$1,535,303

Divided by

Sales $1,345,803

Asset Turnover

0.88

Return on Assets

6.84%

X

Return on Equity

8.76%

X


43

Cut Overhead Expense as a Percent of Sales by 3%


+ Long-term

Liab. $266,970

Total Assets

$1,535,303

Total Liab.

$336,376

less

Total Assets

$1,535,303

Net Worth

$1,198,927


1.28

Sales $1,345,803

COGS $878,633


Operating Expense

$349,909

Expense Percent

26%

Gross Margin

34.71%

less

less Operating

Profit $117,261

less Federal Taxes

$0


Sales $1,345,803


Margin 8.71%

Inventory Turnover

1.61

Age of Accts. Rec.

55

Inventory $833,393

Accts Receivable

$202,085

+

+

Cash $35,502

Current Assets

$1,070,980


Total Assets

$1,535,303

Divided by

Sales $1,345,803

Asset Turnover

0.88

Return on Assets

7.64%

X

Return on Equity

9.78%

X


44

Increase Inventory Turns By 1


+ Long-term

Liab. $266,970

Total Assets

$1,219,526

Total Liab.

$336,376

less

Total Assets

$1,219,526

Net Worth $883,150


1.38

Sales $1,345,803

COGS $878,633


Operating Expense

$392,924

Expense Percent

29.20%

Gross Margin

34.71%

less

less Operating

Profit $74,246

less Federal Taxes

$0


Sales $1,345,803


Margin 5.52%

Inventory Turnover

2.60

Age of Accts. Rec.

55

Inventory $517,616

Accts Receivable

$202,085

+

+

Cash $35,502

Current Assets $755,203


Total Assets

$1,219,526

Divided by

Sales $1,345,803

Asset Turnover

1.10

Return on Assets

6.09%

X

Return on Equity

8.41%

X


45

Reduce Receivables To 30 Days


+ Long-term

Liab. $266,970

Total Assets

$1,443,832

Total Liab.

$336,376

less

Total Assets

$1,443,832

Net Worth

$1,107,456


1.30

Sales $1,345,803

COGS $878,633


Operating Expense

$392,924

Expense Percent

29.20%

Gross Margin

34.71%

less

less Operating

Profit $74,246

less Federal Taxes

$0


Sales $1,345,803


Margin 5.52%

Inventory Turnover

1.61

Age of Accts. Rec.

30

Inventory $833,393

Accts Receivable

$110,614

+

+

Cash $35,502



Total Assets

$1,443,832

Divided by

Sales $1,345,803

Asset Turnover

0.93

Return on Assets

5.14%

X

Return on Equity

6.70%

X


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Combined Effects • Increase Gross Margin 2% • Cut Overhead by 3% • Increase Inventory Turns by 1 • Reduce Age of Accts. Rec. to 30 days


+ Long-term

Liab. $266,970

Total Assets

$1,128,055

Total Liab.

$336,376

less

Total Assets

$1,128,055

Net Worth $791,679


1.42

Sales $1,345,803

COGS $878,633


Operating Expense

$349,909

Expense Percent

26%

Gross Margin

37%

less

less Operating

Profit $148,038

less Federal Taxes

$0


Sales $1,345,803


Margin 11%

Inventory Turnover

2.60

Age of Accts. Rec.

30

Inventory $517,616

Accts Receivable

$110,614

+

+

Cash $35,502



Total Assets

$1,128,055

Divided by

Sales $1,345,803

Asset Turnover

1.19

Return on Assets

13.12%

X

Return on Equity

18.70%

X


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