How can you recognize warning signs indicating financial distress on your farm? Although many farm proprietors and managers have a solid grasp of their farm business’s profit dynamics, they frequently overlook the critical aspect of assessing financial resilience. The financial resilience of a business can be gauged by examining liquidity and solvency ratios. In fact, a majority of agricultural lenders, including commercial banks and institutions within the farm credit system, actively consider these ratios as part of their evaluation during the farm loan approval process.
To compute these ratios, you should initially create financial statements, such as the balance sheet and income statement. While the manager and/or owner might not be the ones directly creating these statements, it’s crucial for them to comprehend the insights these statements offer regarding the business’s financial health and ways to enhance weak financial performance. Emphasizing the importance of maintaining accurate records and regularly producing these statements is strongly recommended, as they prove beneficial during tax filings, loan applications, and gaining insights into the current financial status of the business.
Liquidity metrics assess a debtor’s capability to settle existing debt commitments without seeking external funding. These metrics are primarily derived from components of the balance sheet’s current assets and current liabilities. Current assets comprise assets easily converted into cash, like cash, bank accounts, investments, and inventories. Current liabilities consist of obligations due within a year, such as accounts payable, production loans, and current portions of noncurrent debt. The most commonly employed liquidity metric is the current ratio, expressed as:
Current Ratio = Current Assets/Current Liabilities
A higher liquidity ratio indicates that the dollar value of current assets surpasses the value of short-term debt obligations, which is favorable.
While liquidity ratios focus on the present timeframe, solvency ratios assess a farm business’s capacity to cover all liabilities with its total assets. Unlike liquidity ratios, it is necessary to consider the dollar values of both long-term and short-term assets and liabilities on the balance sheet. This includes the dollar value of farmland (a long-term asset) and farmland loans (a long-term liability), which often represent a significant portion of a farm’s balance sheet. The most widely utilized solvency metric is the debt-to-asset ratio, expressed as:
Debt to Asset Ratio = Total Liabilities/Total Assets
In contrast to the current ratio, one must divide the dollar value of total liabilities (financial obligations) by the dollar value of total assets. A high debt-to-asset ratio may indicate insolvency, signaling that the value of total liabilities surpasses total assets.
Compare Your Numbers with Benchmarks
The Farm Financial Standards Council (FFSC) establishes benchmarks for these ratios, which are periodically updated, although not significantly. According to the FFSC, it is considered favorable to have a current ratio exceeding 2 and a debt-to-asset ratio lower than 0.6. It is highly recommended that farmers and ranchers assess their liquidity and solvency measures against these benchmarks and take corrective measures if their figures fall short. These can be done through, but not limited to, selling of farm assets that are not in use, raising equity capital through ownership restructuring, and renegotiating on long-term debt.
Additionally, it is wise to compare these numbers with national, regional, and specialty-specific averages, as some lenders may evaluate an applicant’s information in relation to other peer groups when deciding on approvals. Individuals can compare their figures with peers based on specialty, region, size, and age group using the USDA Economic Research Service’s report, accessible through the following link: https://my.data.ers.usda.gov/arms/tailored-reports
Also, it is a good idea to keep track of these ratios over time, to see whether the financial resiliency of one’s business is improving or deteriorating.
Kim, Kevin, and Brian E. Mills. “Financial Ratios to Consider for Measuring Financial Resiliency of Your Farm.” Southern Ag Today 4(2.3). January 10, 2024. Permalink