The Ag Globe TrotterDr. Dave M. Kohl
Welcome to the weekly edition of The Ag Globe Trotter by Dr. Dave Kohl.
The financial records from the previous year are in the books. The dead of winter is a good time to take stock of where you have been and where you are going. The pandemic and all of the other abnormalities can make everything feel abnormal and difficult to predict, but this only increases the priority of focusing on your finances. What are some of the financial numbers and ratios that are important to monitor on your financial statements?
Term Debt and Lease Coverage Ratio
As a facilitator of the original Farm Financial Standards Council task force, one of the key ratios for viability of the business is the term debt and lease coverage ratio. In basic terms, this ratio measures the amount of cash flow available for total principal and interest payments after all expenses (excluding interest and depreciation expenses), family living costs and income taxes are deducted. Examine your coverage ratio for the year 2021 and compare it to the three-to-five-year trend. How important were both recurring and nonrecurring government payments to the ability to meet your debt service commitments? Project the future impact of inflating expenses and profit margin compression on meeting your debt service obligations. In my decades of working with financials and as an agribusiness owner, a ratio above 150% is quite good. At 120%% or less, one must examine how the ratio could be improved. Some strategies could be cutting the right cost, reducing family living withdrawals, supplementing with nonfarm revenue, improving revenues through price or production, or a combination of all of the above.
Current assets and current liabilities, otherwise known as the top half of the balance sheet, will need special focus in 2022 and beyond. Net worth on farm and ranch balance sheets has improved. In some cases, the improvement is a result of retained earnings while others appreciated net worth through inflation. As inflated cost structures decrease margins or create negative results, working capital is your fallback position in case of financial adversity.
Of course, the standard current ratio measured by dividing current liabilities by current assets will be a good discussion metric with your lender and owner management team. Another one of my favorites is working capital divided by total expenses or total revenue. What percent of your revenue and expenses can be generated by internal working capital? While a current ratio of 1.5 to one is quite strong, a working capital to expense ratio above 20% to 30% is also desirable.
Again, trend analysis along with projections on a pro forma balance sheet can be a valuable monitoring device. While there are many other financial ratios that are important, these two ratios should be calculated by Presidents' Day by digging in and energizing these two critical metrics.
Dr. Kohl is Professor Emeritus of Agricultural Finance and Small Business Management and Entrepreneurship in the Department of Agricultural and Applied Economics at Virginia Polytechnic Institute and State University. Dr. Kohl has traveled over 8 million miles throughout his professional career and has conducted more than 6,000 workshops and seminars for agricultural groups such as bankers, Farm Credit, FSA and regulators, as well as producer and agribusiness groups. He has published four books and over 1,300 articles on financial and business-related topics in journals, extension and other popular publications.
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