Analysis of the financial information of a farming business
Thus far in our series of articles we have discussed various aspects of the management of a farming business. Included was discussions on record-keeping and financial management culminating in the compiling of financial statements – that is a balance sheet, income statement and a cash-flow statement. The information from the statements then provides one with a picture of the success of your business.
Financial record-keeping and compiling of the necessary financial statements is necessary to supply the financial information to determine the financial result (profit/loss) through an Income Statement, the financial position (ratio of assets) related to liabilities through a Balance Sheet and the cash-flow position via a Cashflow Statement.
To be able to determine whether your business is really successful you should be able to compare your business with other businesses. To do this we need to go one step further and that is to analyse and interpret the results from the financial statements by means of financial ratios. Once you in a position to do this, it will serve to make all your record-keeping worth your while. By interpreting the financial ratios you will be provided with proper answers to which aspects of your business needs attention to improve and advance your business. This is important because to be successful and farm sustainable over a long period you need to improve your business every year.
Financial analyses can be divided into five groups, namely Solvability, Liquidity, Profitability, Debt-Servicing and Efficiency. In total there are some 16 ratios to be used but we will only concentrate on four ratios – the most fundamental ones.
First of all Solvability with the first ratio being the Net Capital Ratio. Solvability indicates the extent to which the assets of a business exceed the liabilities, and thus the ability of the business to meet its liabilities should the activities of the business be terminated. Thus in simple terms the ratio indicates whether the business is solvent or insolvent (bankrupt). To calculate this ratio information is taken from the balance sheet namely Total Assets/Total Liabilities.
The rule of thumb is that a ratio exceeding 2:1 (R2,00 assets for every R1,00 liabilities) is safe. In practice if this ratio is under 2:1 say 1.4:1 it means you have too much debt and you should reduce your debt. You can do this by increasing the income of your business and/by reducing the expenditures. By achieving this you will increase the profit business which can then be used to reduce the debt.
Secondly, Liquidity indicates the continued ability of the business to timeously meet all current or short term debt needed to be paid to run your business from day to day. The ratio to be calculated to measure this ability is the Current Ratio. To calculate this ratio information is also taken from the balance sheet namely Current Assets/Current Liabilities.
The rule of thumb is also, should the ratio exceed 2:1 (R2,00 current assets for every R1,00 current liabilities) it is safe. In practice if this ratio is under 2:1 say 1.55:1 there is a high probability that you will find it difficult to pay short term debtors in time. This could eventually force a solvent farmer into liquidation or insolvency. Therefore you must manage your current liabilities properly and pay them as required.
Thirdly, the Profitability of a farm is calculated by expressing the Net Farm Income (NFI) as a percentage of the total capital employed in the farming business during a financial period. The information for the NFI is taken from the income statement and the information for the total capital employed is taken from the balance sheet and the ratio is then expressed as a percentage. It is a fact that farming businesses realises a rather low profitability. It could be as low as 7% depending on the type of farming.
In practice should this figure become lower, say 4% one must ask yourself the question is it worthwhile to continue with this business or what can I do to improve. You can put your money in a savings account with a financial institution and earn at least 5,5% interest without all the risk and hard work.
Fourthly, Debt Servicing is normally judged by using the information as portrayed in the cash-flow statement. A very important issue and when applying for credit the financier will have a thorough look at your cash-flow statement. You can also calculate the Cash-flow ratio being Cash-income/Cash-outflow using the information from your cash flow statement and expressing it as a percentage. Normally it is regarded that this ratio should be 120% and higher indicating that you should have enough cash available to pay all debt and all other farming expenses as required.
The advantage of using the different ratios is that it is then possible to compare different farming businesses with each other and get a good indication of the success of your business.
Article submitted by Marius Greyling, Pula Imvula contributor
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Publication: June 2016