Financial Guideline Measures

The Farm Financial Guidelines is a cooperative effort of agricultural producers, lenders, economists, financial consultants and Congressional leaders. It suggests standardized farm financial ratios, definitions, and reporting formats that can be used in analyzing a farm's financial position and performance.

Liquidity: The ability of the farm business to generate sufficient cash flow for family living, taxes, and debt payments.

The "Current Ratio" shows the value of current assets relative to current liabilities. It measures the extent to which current farm assets if liquidated would cover current farm liabilities.

Current Ratio = Total Current Farm Assets ÷ Total Current Farm Liabilities.

"Working Capital" approximates the amount of funds available from within the business to purchase crop and livestock inputs and equipment necessary to produce farm products.

Working Capital = Current Farm Assets - Current Farm Liabilities

Solvency: The ability to pay all debts if the business were liquidated. Solvency analysis includes an evaluation of the current net worth of the farm business, the projected future growth in net worth, and the way debts are structured.

The "Farm Debt to Asset Ratio" compares the total liabilities to the total assets. It measures the portion of the farm assets that have debt against them. A higher ratio is generally considered to be an indicator of greater financial risk. 

Farm Debt to Asset Ratio = Total Farm Liabilities ÷ Total Farm Assets

The "Farm Equity to Asset Ratio" measures the proportion of the farm assets financed by the owner's equity whereas the debt to asset ratio measured the proportion of farm assets financed by debt. When added together these two measures always add up to 100 percent because they describe how total farm assets are financed.

 Farm Equity to Asset Ratio = Total Farm Equity ÷ Total Farm Assets

The "Farm Debt to Equity Ratio" measures the amount of farm debt relative to the amount of farm equity or net worth. Stated another way, it measures the amount of borrowed capital being employed for every dollar of equity capital.

Farm Debt to Equity Ratio = Total Farm Liabilities ÷ Total Farm Equity

Profitability: The measure of how much income the business is making in relation to the resources used to produce that income. Over time, profits drive the liquidity and solvency of a farm business. Without adequate profitability, future growth in net worth from farm operations is not possible.

The "Rate of Return on Assets" is, in effect, the interest rate your farm earned on all money invested in the business. If assets are valued at market value, the rate of return on investment can be looked at as the "opportunity cost" of investing money in the farm instead of alternative investments. If assets are valued at cost (cost less depreciation), the rate of return represents the actual return on the average dollar invested in the business.

Rate of return on assets = Return on farm assets ÷ Average farm investment

Where:

Return on farm assets = net farm income + farm interest - value of operator's labor& management

And:

Average farm investment = (beginning total farm assets + ending total farm assets) ÷ 2

The "Rate of Return on Equity" is, in effect, the interest rate earned on farm net worth. Like the rate of return on assets, if assets are valued at market value, this return can be compared with returns available if the assets were liquidated and invested in alternative investments. If assets are valued at cost, this represents the actual return to the amount of equity capital you have invested in the farm business.

 Rate of Return on Equity = Return on Farm Equity ÷ Average Farm Net Worth

Where:

Return on Farm Equity = Net Farm Income - Value of Operator's Labor and Management

And:

Average Farm Net Worth = (Beginning Farm Net Worth + Ending Farm Net Worth) ÷ 2

"Operating Profit Margin" is a measure of the operating efficiency of the business. If expenses are held in line relative to the value of output produced, the farm will have a healthy Operating Profit Margin. A low Operating Profit Margin may be caused by low prices per unit sold, high overhead expenses, or inefficient production.

Operating Profit Margin = Return on Farm Assets ÷ Value of Farm Production

Where:

Value of farm production = gross cash farm income - feeder livestock purchases - purchased feed (adjusted for inventory change of crops, market livestock, and breeding livestock)

"Net Farm Income" represents returns to the unpaid operator labor, management, and equity capital invested in the business. In other words, this is the amount a family earned for putting your time and for investing your net worth in the farm operation.

Net Farm Income = Net Operating Profit – Depreciation and Other Capital Adjustments

Where:

Net Operating Profit = Net Cash Farm Income (+ or -) Inventory Changes

And:

Net Cash Farm Income = Gross Cash Farm Income - Cash Operating Expenses

Repayment Capacity:

The "Term Debt Coverage Ratio" measures whether your operation generated enough cash over the past year to cover principal and interest payments on term (intermediate and long term) debt.

Term Debt Coverage Ratio = Amount Available for Principal and Interest Payments on Intermediate and Long Term Debt ÷ Principal and Interest Payments Due on Intermediate and Long Term Debt (farm and non-farm)

Where:

Amount Available for Principal and Interest Payments on Intermediate and Long Term Debt =

 Net Cash Farm Income

+ Non-Farm Income

+ Scheduled Term Debt Interest Expense

- Family Living and Taxes

The "Capital Replacement Margin" is the amount of money remaining after all operating expenses, taxes, family living and scheduled debt payments have been made. It is the cash generated by the farm business that is available for financing the purchase of capital replacement such as machinery and equipment.

Capital Replacement Margin = Amount Available for Principal Payments + Interest Due on Intermediate and Long Term Loans - Scheduled Principal and Interest Payments

Efficiency:

The "Asset Turnover Rate" is a measure of efficiency in the use of capital. If low, it indicates the current level of investment needs to be used more efficiently. If not, maybe some capital can be sold without adversely affecting operating efficiency.

Asset Turnover = Value of Farm Production ÷ Total Farm Assets

Where:

Value of Farm Production = gross cash farm income - feeder livestock purchases - purchased feed + or - inventory change of crops, market livestock, and breeding livestock

The "Operating Expense Ratio" indicates the percent of the gross farm income that is used to pay the operating expenses.

Operating Expense Ratio = (Farm Operating Expense - Farm Interest Expense) ÷ Gross Farm Income

The "Depreciation Expense Ratio" indicates the percent of the gross farm income that is used to cover the depreciation expense.

Depreciation Expense Ratio = Depreciation ÷ Gross Farm Income

The "Interest Expense Ratio" indicates the percent of the gross farm income that is used to pay farm interest expenses.

Interest Expense Ratio = Farm Interest Expense ÷ Gross Farm Income

The "Net Farm Income Ratio" indicates the percent of the gross farm income that remains after expenses as net farm income.

Net Farm Income Ratio = Net Farm Income ÷ Gross Farm Income

Note: The last four ratios are often referred to as operational ratios. The sum of the Operating Expense Ratio, the Depreciation Expense Ratio, and the Interest Expense Ratio equals the percent of gross income that is used to pay the business expenses. The remaining gross income is the amount that becomes the Net Farm Income. Therefore all four ratios when added together always equal 100 percent of the gross farm income.