Centre of advanced valuation and real estate practice
Reproduced with permisson
INDICATORS
OF FARM PERFORMANCE
Performance
indicators range from standard financial ratios [equity, return on
capital] to rules of thumb which should be regarded as a
further guide to profitability, efficiency, or business health. A
range of indicators is recommended as a good performance on one
measure does not imply a good performance on any other measure. For
example, the cash surplus may be adequate to cover household living
costs. However, if the capital base is high in value relative to
income a poor return on capital will result. In combination, the two
indicators enhance the interpretation of the business position.
The
following are a number of useful ratios and indices which are used by
industry to measure a farm's performance. None is inherently superior
to the others but rather, one measure is better for certain
industries and certain purposes than are the others.
THE
CASH FLOW
The
expected cash flow measures the farmer's ability to meet all
commitments including interest and principal payments. As such it is
a measure of liquidity. A Cash Flow Deficit should be viewed in the
context of the size of the farm business and potential production.
Cash flow may be very sensitive to price or yield eg a 5% yield
increase may convert a deficit to surplus.
Care
should always be exercised when preparing these statements to include
non farm assets, and personal receipts and payments if the whole
business is being examined but excluded if the analysis is for the
farm business only.
Care
should also be taken to specify whether the statements are prepared
for the current financial year or using "year in, year out"
figures. Average prices and yields may be chosen to give a longer
term view of business prospects.
ASSETS
AND LIABILITIES
Statements
of assets and liabilities measure solvency, liquidity and leverage.
SOLVENCY
Is
the ability to meet financial obligations as they fall due. When
assets are clearly in excess of liabilities there is a buffer against
future losses. An excess of liabilities over assets indicates an
insolvent position as creditors would not fully recover advances in a
wind up of the business.
The
Assets and Liability statement is an indication of leverage or
gearing. With high debt there is potential for rapid growth in owner
equity when the business is profitable and there is the risk of rapid
equity loss if the business is unprofitable.
PROFIT
ANALYSIS
An
analysis of the profit statement takes the analysis of
business health a step further than the cash flow statement.
To calculate Farm Operating Profit certain changes to Cash
Surplus/Deficit are made. Previously deducted items such as personal
expenses and principal repayments on loans are added back to cash
surplus/deficit. Plant depreciation and changes in stocks are also
accounted for here.
LEVERAGE
(GEARING) RATIOS
EQUITY
RATIO (ER)
Equity
is a measure of net assets, usually expressed as a proportion of
total assets. ER is the net assets (total assets-total liabilities)/
total assets.
ER
= (TA-TL)/TA
Where:
ER
= equity ratio
TA
= total assets
TL
= total liabilities
ERs
should be interpreted in conjunction with cash flow as follows:
FARM
BUSINESS'S POSITION AND FARMERS' ADJUSTMENT NEEDS
| FARM
BUSINESS CATEGORY |
EQUITY % |
|
|
|
|
DEFICIT
|
SURPLUS
|
|
|
<-50 |
-50 |
-25 |
+25 |
+50 |
>50
|
STRONG
|
80-100
|
0
|
0
|
0 |
1
|
1
|
1 |
DAMAGED
|
60-79 |
0
|
0
|
0
|
2 |
2
|
2 |
| AT
RISK |
40-59 |
0 |
0 |
0 |
2 |
2 |
2 |
| CRITICAL |
<40 |
3 |
3 |
3 |
2 |
2 |
2 |
0
= in need of business adjustment & family income assistance
1
= in a position to assess expansion and off-farm opportunities
2
= need to increase or retrieve equity
3
= need of family income assistance & to consider leaving farming
EQUITY
IN LAND RATIO
Provides
a more precise indicator of financial security from the viewpoint of
the owner as a borrower and the lender. However, land value will
often include non agriculture value and therefore it must be
remembered that the ratio is not measuring agricultural viability
alone.
EL
= (TLA-SL)/TLA
Where:
EL
= equity in land
TLA
= total land assets
SL
= secured liabilities
The
need to maintain high levels of equity in land is reemerging as
important in the 1990s because of lower farm incomes, difficulty in
servicing debt and more conservative lending by banks.
ACTIVITY
RATIOS
LAND
ASSETS TURNOVER (TOTAL FARM RECEIPTS TO LAND ASSETS) RATIO
This
measure provides an indication of turnover (receipts) in relation to
total assets. Obtained by dividing total farm receipts by investment
in land and improvements:
LAT
= TFR/TLA
Where:
LAT
= land assets turnover ratio
TFR
= total farm receipts
TLA
= total land assets
By
including land value the ratio is more than likely, measuring an
urban influence and in that case, is not a good indicator of
agricultural viability.
PROFITABILITY
RATIOS
Profitability
ratios are most useful to the valuer as they can be easily extended
or modified to allow the determination of the expected net annual
income for use in the capitalization method of valuation.
TOTAL
GROSS MARGIN TO TOTAL FARM RECEIPTS RATIO
Total
gross margin comprises total farm receipts less variable costs. As
such it provides a measure of profitability in allowing an assessment
of margin to cover overhead payments debt servicing and personal
drawings.
TGM
= TFR - VC
Where:
TGM
= total gross margin
TFR
= total farm receipts
VC
= variable costs
If
TGM comprises 0.75 or greater of total farm receipts it is likely
that a safe margin is available for overheads, debt service and
drawings. This is a good measure of the agricultural viability of the
farm operation. It indicates the surplus over variable costs
available to meet overheads, interest and personal payments. A low or
negative gross margin is a clear indicator of financial difficulty.
SOLVENCY
AND LIQUIDITY
CURRENT
[LIQUIDITY] RATIO
This
ratio measures the ability of the farm business to meet its present
and short term obligations.
DEFINITION
The
current ratio obtained by dividing current assets by current
liabilities. In the context of the Farm Business Evaluation Package
current assets include cash deposits, and marketable securities,
sundry debtors, grain pool equities, produce and materials and the
value of growing crops and saleable stock and livestock products
[wool etc]. Current liabilities include store accounts, unsecured
debts payable, rates and income tax due, currently maturing long term
debt and other accrued expenses such as wages.
CALCULATION
OF CURRENT RATIO
CR
= CA/CL
Where:
CR
= current ratio
CA
= current assets
CL
= current liabilities
INTERPRETATION
0
1.0
2.0
3.0
---------------------------------------------------------------------------------------------->
non
liquid
liquid
highly liquid
A
ratio of 1 shows that short term debts and obligations can be met by
liquid assets including inventories, equity in pools and imminent
sales of produce. A ratio less than 1 indicates degrees of
illiquidity. A ratio of 2 or 3 indicates that short term assets cover
liabilities by several times.
OTHER
RATIOS
QUICK
RATIO
The
quick ratio provides a measure of liquidity without the necessity of
selling inventories, perhaps at less than market value.
DEFINITION
OF QUICK RATIO
The
quick ratio is obtained by dividing current assets less inventories
by current liabilities. [see above for asset and liability
definitions].
CALCULATION
QR
= (CA-INV)/CL
Where:
QR
= quick ratio
CA
= current assets
INV
= inventories
CL
= current liabilities
INTERPRETATION
OF QUICK RATIO
As
for the Current Liquidity Ratio. As inventories are less liquid than
cash etc they may incur losses on a quick sale. If current
liabilities can be paid without sale of stocks on hand an initial
test of solvency is satisfied.
DEBT
SERVICING RATIO [INTEREST TO CASH SURPLUS RATIO] (DSR)
The
debt servicing ratio [DSR] is the ratio of interest payments [not
including repayment of principal] to the sum of farm cash operating
surplus and interest payments. Murdock & Leistritz [1988] define
debt service ratio as a measure of the adequacy of income to service
debt. Further, they say it is intended to measure the income
available to pay principal and interest payments.
DEFINITION
OF DSR
The
ratio of interest and principal payments to the sum of farm cash
surplus plus interest and principal payments. Farm Cash Surplus
comprises total farm receipts less farm payments, total personal
drawings, interest and principal payments. Alternatively, debt
servicing ratio may be defined as INTEREST PAYMENTS ONLY divided by
farm cash surplus plus interest and principal payments. This
definition is on the assumption that principal payments have been
deferred by arrangement with creditors.
CALCULATION
OF DSR
DSR
= (I+P)/(CS+I+PP)
Where:
DSR
= debt servicing ratio
I
= interest
P
= principal
CS
= cash surplus
PP
= principal payments
INTERPRETATION
OF DSR
< 1.0
0.5
0
0.5
> 1.0
------------------------------------------------------------------------------------------------------------->
no
debt
service
full debt
service
partial debt service
With a ratio of
between 0 and 1, the business can service debt fully but within this
range there are critical levels. Clearly, as the ratio approaches 1,
the area of merely partial debt service is reached, if household and
other farm expenses are to be met.
VIABILITY
RATIO [DEBT SERVICE TO PROFIT RATIO] (VR)
The
annual household net income divided by annual household obligations
ie. net cash farm income plus off farm income divided by
principal payments on debt, household consumption and capital
replacement costs. The concept is useful because it gives a broader
view of the farmer's financial status than the debt servicing ratio.
It includes off farm and unearned income [interest etc.] and
consideration of depreciation, inventory changes and the imputed
value of farm labour.
DEFINITION
OF VIABILITY RATIO
May
be defined as "Interest and Principal paid divided by Farm
Operating Profit [FOP] plus Total Personal Receipts [off farm
income and interest earned] and Interest Payments.
CALCULATION
OF VR
VR
= (I+P)/(FOP+TPR+I)
Where:
VR
= viability ratio
I
= interest
P
= principal
FOP
= farm operating profit
TPR
= total personal receipts
INTERPRETATION
<
1.0
0.5
0
0.5
> 1.0
------------------------------------------------------------------------------------------------------->
non
viable
non
viable
viable
area
non viable
Within
the range; 0 to 1 indicates the farm business [and household] is able
to improve wellbeing during the year that is, meet all obligations
including farm payments [overhead and variable] family living
expenses and depreciation. However, a ratio of >1 or <0
indicates inability to meet all financial obligations during the
year.
DEBT
SERVICING TO TOTAL FARM RECEIPTS RATIO (DSR)
This
ratio indicates the proportion of gross receipts absorbed by interest
and principal payments. Safe levels of debt servicing as a proportion
of gross income are flexible depending on other commitments, costs of
production and personal drawings.
CALCULATION
DSR
= (I+P)/TFR
Where:
DSR
= debt servicing ratio
I
= interest
P
= principal
TFR
= total farm receipts
INTERPRETATION
OF DSR
0
0.25
0.5
0.75
1.0
-------------------------------------------------------------------------------------------------->
safe
at
risk
critical
Debt
servicing costs of 25% is considered to be the safe maximum of TFR.
As this percentage rises it becomes harder to service debt, and meet
other costs, especially in a downturn. The manner in which TFR may be
allocated, assuming TFR of $100 000 is as follows:
Farm
Payments [O/H and VC] $ 50 000 [50%
Debt
Servicing [Principal + Int] $ 20 000 [20%]
Plant
Depreciation $ 10 000 [10%]
Personal $
10 000 [10%]
Profit
and Contingencies $ 10 000 [10%]
TOTAL: $100
000 [100%]
(Cook
& Rowan, 1993)
LEVERAGE
(GEARING) RATIOS
EQUITY
RATIO (E)
Equity
is a measure of net assets, usually expressed as a proportion of
total assets.
CALCULATION
E
= (TA-L)/L
Where:
E
= equity ratio
TA
= total assets
L
= liabilities
INTERPRETATION
OF E
0
0.2
0.4
0.6
0.8
1.0
---------------------------------------------------------------------------------------------------------------->
critical
at
risk
damaged
strong
EQUITY
IN LAND RATIO (EL)
This
measure provides a more precise indicator of financial security, from
the viewpoint of the farm owner as a borrower and a lender.
CALCULATION
OF EL
The
issue of land value is vital to the calculation of this measure and
again raises the problem of whether or not there is an urban
influence in that value. Equity in land may be calculated as:
EL
= (TLA - SL) /TLA
Where:
EL
= equity in land
TLA
= total land assets
SL
= total liabilities
INTERPRETATION
OF EL
0.25
0.5
0.8
1.0
--------------------------------------------------------------------------------------------------->
critical
at
risk
strong
The
need to maintain [or retrieve] high levels of equity in land is
reemerging as important in the 1990's, because of lower farm incomes
[and difficulty in servicing debt] and more conservative lending by
banks.
DEBT
TO ASSET RATIO
This
ratio shows the percentage of funds that has been provided by
creditors compared with equity provided by owners.
CALCULATION
DAR
= TL/TA
Where:
DAR
= debt to asset ratio
TL
= total liabilities
TA
= total assets
INTERPRETATION
0
0.2
0.4
0.6
0.8 1.0
--------------------------------------------------------------------------------->
strong
damaged at
risk
critical
Debt
ratios in the range 0 to 0.2 are considered "safe" or
strong. Creditors also prefer this range. Strong and stable cash
flows are required to support debt ratios above 0.4.
ACTIVITY
RATIOS
LAND
ASSETS TURNOVER RATIO
(TOTAL
FARM RECEIPTS/LAND ASSETS RATIO) (LAT)
This
measure provides an indication of turnover [receipts] in relation to
total assets.
CALCULATION
OF LAT
LAT
= TFR/TLA L
Where:
LAT
= land assets turnover ratio
TFR
= total farm receipts
TLA
= total land assets
INTERPRETATION
0.0
0.25
0.5
0.75
1.0
---------------------------------------------------------------------------------------------------------------->
weak
satisfactory
strong
Turnover
in relation to assets will vary from district to district. Standards
for this measure are not available at present.
TOTAL
ASSETS TURNOVER RATIO (TAT)
This
ratio takes account of all assets employed in generating productions
and income.
CALCULATION
OF TAT:
TAT
= TFR/TA
Where:
TAT
= total assets turnover ratio
TFR
= total farm receipts
TA
= total assets
INTERPRETATION
0.0
0.25
0.5
0.75
1.0
------------------------------------------------------------------------------------------------------------->
weak
satisfactory
strong
Turnover
in relation to assets varies from district to district. Standards for
this measure are not available at present.
FARM
TO NON FARM RECEIPTS RATIO (FNF)
This
ratio measures the extent of reliance of the business on non farm
receipts. This dependence may be high due to inadequate cash flow or
it may be incidental to farm operations.
CALCULATION
OF FNF:
FNF
= TOR/(TR-CR)
Where:
FNF
= farm to non farm receipts ratio
TOR
= total operating receipts
TR
= total receipts (operating + non farm receipts)
CR
= capital receipts
INTERPRETATION
0
0.5
1.0
---------------------------------------------------------------------------->
high
non
farm
low non farm
A
ratio of 0.5 or higher indicates a low dependence on non farm
sources of income; less than 0.5 indicates a high dependence and
perhaps need of off farm income.
PROFITABILITY
RATIOS
These
ratios are most useful to the valuer as they are ratios which use
part of the expected net annual income as a comparative measure of a
farm's viability.
TOTAL
GROSS MARGIN/ TOTAL FARM RECEIPTS RATIO (TGMR)
Total
gross margin comprises total farm receipts less variable costs. As
such it provides a measure of profitability in allowing an assessment
of margin to cover overhead payments debt servicing and personal
drawings.
CALCULATION
OF TGMR:
TGMR
= TFR - VC
Where:
TGMR
= total gross margin ratio
TFR
= total farm receipts
VC
= variable costs
INTERPRETATION
0
0.25
0.5
0.75
1.0
--------------------------------------------------------------------------------------------------------------->
poor
marginal
good
Little
farm data is available to provide guidelines on safe levels of gross
margin. However, if total gross margin comprises 0.75 or greater of
total farm receipts it is likely that a safe margin is available for
overheads, debt service and drawings.
FARM
PAYMENTS RATIO (FPR)
This
ratio provides a check on the level of operating costs in relation to
income. Care in interpretation is needed, especially at times of
depressed and/or abnormally high returns.
CALCULATION:
OF FPR
FPR
= FP/TFR
Where:
FPR
= farm payments ratio
FP
= farm payments
TFR
= total farm receipts
Farm
Payments include both overhead and variable costs but exclude
interest, capital and personal payments.
INTERPRETATION
OF FPR
0
0.2
0.4
0.6
0.8
1.0
---------------------------------------------------------------------------------------------------------------->
good
average
poor
A
convenient guideline is that farm payments [overhead and variable
costs] are 50% of TFR or less. This will allow scope for personal
payments, debt servicing [interest and principal] and plant
depreciation. As farm payments rise above 50% TFR, debt servicing or
personal payments will be squeezed.
RETURN
ON CAPITAL (ROC)
These
are useful ratios for valuation practice as they enable a direct (but
often unreliable) comparison with other farms and opportunity cost
investments. The calculation of Return on Capital removes the
influence of interest payments indicator of profit and relates
profitability to invested capital.
CALCULATION
OF ROC:
ROC
= [FP + I + LR] x 100/ TA
Where:
ROC
= return on capital
FP
=
I
=
LR
=
TA
= total assets
INTERPRETATION
OF ROC
< 5%
0
5%
>10%
------------------------------------------------------------------------------------------------->
Low
Fair
Satisfactory
Good
ROC
indicates the degree of indebtedness that a property may carry. For
example, a farm returning say 5% on capital invested may service,
risk aside, a debt equivalent to one third of total capital at an
interest rate of 15%. Whereas a farm returning 10% on capital may
service up to two thirds of total farm capital as debt.
A
reasonable Return on Capital probably indicates sound productivity
and/or appropriate cost structure and may allow the servicing of
relatively high debt level. However, the risk element of high debt,
in exposure to interest rate increases and income downturn, are the
key ingredients of farm financial collapse from the late eighties
into the nineties.
RETURN
ON EQUITY (ROE)
DEFINITION
Return
on Equity [ROE) is the Return on Capital [ROC] - Interest [I] / Owner
Equity
CALCULATION
OF ROE:
ROE
= [ROC I] / [TA - TD]
Where:
ROE
= return on equity
ROC
= return on capital
TA
= total assets
TD
= total debt
INTERPRETATION
OF ROE
< 5%
0
5%
>10%
----------------------------------------------------------------------------------------------------------------->
unsatisfactory
fair
satisfactory
good
A
positive ROE may be achieved by a debt free farm earning a low or
modest Return on Capital or a farm with a higher debt level and a
high Return on Capital. Currently cash flow problems arise because
highly indebted farms are achieving low or negative Return on
Capital. This may be far less than the Interest paid on debt.
See
farm performance and sustainability