By Morgan Stutrud
Originally published by Dakota Farmer at farmprogress.com
Financial ratios play a crucial role in evaluating the performance and viability of a farm, serving as key tools for both farm owners and external stakeholders such as creditors and tax authorities.
While these ratios are commonly associated with businesses in various industries, their significance to a farm operation should not be overlooked.
By definition, financial ratios are a method of quantifying a company’s liquidity, operational efficiency and profitability to evaluate its performance over time and relative to its peers. This comparative aspect is particularly valuable, as it enables farm owners to benchmark their operation against similar ones, regardless of size.
Offering insight
North Dakota Farm Management Edu-cation conducts a comprehensive year-end analysis that produces financial ratios falling under five primary categories.
Each of these ratio types offer insight into different aspects of the farm’s financial performance and stability:
Liquidity. These ratios measure an operation’s ability to pay off its short-term debts as they become due, using the operation’s current assets, or to generate enough cash to pay for family living expenses, taxes and on-time debt payments. Liquidity ratios include:
- current ratio
- working capital to gross revenues
- working capital to operating expenses
Solvency. The ratios measure the ability of the farm business to meet all of its debts, including long-term debt, if it were sold at the current point in time. Solvency ratios include debt-to-asset ratio, debt-to-equity ratio and equity-to-asset ratio.
Profitability. These ratios determine the financial performance of the operation at the end of the year by comparing the difference between the value of goods produced and the cost of the resources used in their production. Profitability ratios include rate of return on assets, rate of return on equity, operating profit margin and asset turnover rate.
Repayment capacity. These ratios show the borrower’s ability to repay debts on time. It includes non-farm income and is not a measure of business performance alone. Repayment capacity ratios include debt coverage ratio, replacement coverage ratio, and term debt coverage ratio.
Efficiency. These ratios show where each dollar of income generated is spent. For example:
- An operating expense ratio shows the portion of gross farm income that is used to pay operating expenses.
- Interest expense ratio shows how much of gross farm income is used to pay for interest on borrowed money.
- Depreciation expense ratio shows what portion of gross farm income is needed to maintain the capital used by the operation.
- Net farm income ratio shows how much is left after all farm expenses are paid.
Understanding your farm’s financial ratios is key to making informed decisions that can drive both short-term improvements and long-term growth. These ratios offer valuable insights into your farm’s financial strengths and weaknesses, guiding strategic decision-making processes.
Be proactive for business
By grasping what these ratios signify and how they reflect your farm’s financial health, you gain the ability to take proactive steps to enhance performance and ensure sustainability. In essence, leveraging your knowledge of financial ratios empowers you to optimize your farm’s operations for success in both the immediate future and in the years to come.
The North Dakota Farm Management Education Program provides lifelong learning opportunities in economic and financial management for those in farming and ranching. For more information, visit ndfarmmanagement.com.
Stutrud is a North Dakota Farm Management Education instructor at Dakota College at Bottineau.
Original Article: https://www.farmprogress.com/farm-business-planning/why-you-should-care-about-financial-ratios