As a young or beginning farmer, you’ll find there are many ways to prepare for the financial aspects of owning a farm. Working with an agricultural lender like Farm Credit from the very start is my first recommendation to be sure that your business is understood and the cyclical nature of the industry is taken into consideration.
The five key financial measures below are used by most lenders in the loan approval process. These indicators should be used regularly by farm and business owners to measure the success of their business.
1. Equity: This measures the financial position and the overall leverage of the borrower. An equity ratio will tell you what you would walk away with if you sold everything you have today and paid off all obligations. A 100% means you do not owe anyone and can keep all of the proceeds from the sale of your assets.
2. Liquidity: This measures a farm’s ability to meet financial obligations in an ordinary course of business (a growing year) without a major disruption to normal operations of the business. Current assets are cash or other farm assets that will be sold in a year. Examples include corn, steers, hay and produce. Assets that are more “liquid” are easier to sell.
An example of a current liability would be loan payments due over the next 12 months and the balance on your line of credit. The higher liquidity would indicate an operation’s ability to pay their bills due over the next 12 months.
3. Profitability: This is the amount earned after both cost of goods sold and operating expenses are subtracted. This indicates a business’s ability to produce profit from normal operations prior to financing costs and owner draws and living expenses.
4. Efficiency: Ultimately, this is the use of assets to generate gross revenues. We look at this in two ways:
- Business efficiency: such as cost control — what percentage of income goes toward expenses? Are costs in line with the specific industry? This also includes asset turnover ratio, which measures the efficiency with which assets generate revenue for the business. The higher the number the better, as this indicates how efficiently the assets or money you’ve invested is generating revenue. This is a problem if land values continue to rise, but income on the farm remains stagnant or even declines.
- Operational efficiency: yield and production figures and measures.
5. Repayment Capacity: This measures the applicant’s ability to repay and what cushion there is for adversity. The higher the better. Often this is in the form of a “coverage ratio” and the cushion will be after all loan payments, including farm and non-farm loans, taxes and living expenses are paid.
It is common to have equity and liquidity exceptions for a young operation, given they are financing a large majority of asset purchases. Additionally, I see poor profitability and efficiency measures in older farm operations that aren’t investing in the right assets to generate the most revenue on the farm.
I can’t understate how important it is to have a solid understanding of your business using these five key financial measures.
If you’re ready to begin farming or improve the financial success of your farm, reach out to our team today at 888-339-3334 or visit mafc.com.
No matter what stage you’re in along the process, we are ready to be your partner.