Forming a clear financial picture of your operation is important. One way to get the information you need is to calculate your operation’s LIQUIDITY, SOLVENCY and PROFITABILITY – three measurements that will help you evaluate your financial situation.
Let’s review the ratios used to calculate these measurements and questions they’ll help you answer. Use the ratio calculators we’ve provided to look at your own numbers.
CAN YOU ACCESS CASH WHEN YOU NEED IT?
Liquidity is the first line of defense when an operation experiences difficulties. Calculate liquidity using the current ratio.
Current Ratio = Current Assets / Current Liabilities
The current ratio calculates an operations ability to meet financial obligations as they come due, without disrupting normal operations. Put simply, can you pay your bills?
Current assets: Short-term liquid assets that can reasonably be converted into cash in a year. Includes cash, inputs (chemicals, seed, fertilizer, feed), finished products (crops in storage, livestock or manufactured output) or accounts receivables.
Current liabilities: Expenses and payments due in a year. Includes unpaid invoices for inputs such as seed and animal feed, mortgage payments (farmland) or a line of credit.
A current ratio above 1 is ideal because it shows current assets are greater than current liabilities. But be mindful that a ratio which is too high can also suggest you aren’t putting your money to work.
CAN YOU MEET YOUR LONG TERM FINANCIAL OBLIGATIONS?
Solvency is the ability of an operation to meet its long-term financial obligations. Calculate your solvency using the debt-to-asset ratio.
DEBT-TO-ASSET RATIO = TOTAL LIABILITIES / TOTAL ASSETS
This ratio measures the proportion of total assets (farmland, buildings, inventory, livestock, etc.) financed by debt, an indicator called leverage.
Total liabilities: Include long-term debt (equipment, vehicles, farmland, mortgage) as well as short-term liabilities (line of credit and unpaid invoices).
Total assets: The sum of current assets (see above) and fixed assets (farmland, buildings and equipment).
A lower debt-to-asset ratio brings flexibility to an operation if it has to withstand unexpected challenges, or to seize opportunities that arise in the marketplace (such as expansion, diversification, etc.)
HOW PROFITABLE IS YOUR OPERATION?
Profitability is the degree to which a business yields profit or financial gain. You can calculate your profitability using the return-on-assets ratio.
RETURN-ON-ASSET = NET INCOME / TOTAL ASSETS
The return-on-assets ratio measures how profitable a company is relative to its total assets and provides insight into how efficiently it uses its assets to generate earnings.
Net income: Revenues minus operating expenses.
Revenues: Cash brought in as a result of business activity. Example: crop yields (or animal weights) multiplied by the price received per bushel (or per pound).
A higher return-on-asset ratio means that a farm is more profitable, and is better able to leverage assets to turn a profit.
If you enjoyed this article, check out the rest of our Anything Ag with FCC series for more!