Financial Check Up

1. Financial Check Up John B. Penson, Jr. Regents Professor and Stiles Professor of Agriculture Texas A&M University

2. Seen the Doc Lately? • Benefits from an annual financial checkup. • Treadmill stress test your financial strength. • Get your vision examined.

3. What is the status of your…. • Liquidity? • Solvency? • Profitability? • Efficiency? • Debt repayment capacity? • Survivability?

4. Key Financial Indicators • Sweet 16 Financial Indicators • Farm Financial Standards Council • www.ffsc.org • Focus today on a few key indicators of liquidity, solvency, profitability, financial efficiency, debt repayment capacity and the implications for survivability.

5. Measures of Liquidity • 1. Current ratio: • Current assets divided by current liabilities. • Demonstrates ability to cover scheduled current liabilities for the • coming year out current assets and still have “cash” left over. • Should exceed 1.0 to be technically liquid. • Some firms fail despite exceeding this hurdle.

6. Measures of Liquidity • 1. Current ratio: • Current assets divided by current liabilities. • Demonstrates ability to cover scheduled current liabilities for the • coming year out current assets and still have “cash” left over. • Should exceed 1.0 to be technically liquid. • Some firms fail despite exceeding this hurdle. • 2. Working capital: • Current assets minus current liabilities. • Expresses liquidity in dollars rather than ratio. • Should be positive. • Cash is King!

7. Liquidity Trends Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

8. Liquidity Trends Survived Failed Minimum Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

9. Liquidity Trends Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

10. Measures of Solvency • 1. Debt ratio: • Total debt divided by total liabilities. • Demonstrates ability to liquidate the firm, cover all liabilities out • of all assets, and still have “cash” left over. • Should not exceed 0.50 to minimize financial risk exposure. • Some firms fail however at lower levels.

11. Measures of Solvency • 1. Debt ratio: • Total debt divided by total liabilities. • Demonstrates ability to liquidate the firm, cover all liabilities out • of all assets, and still have “cash” left over. • Should not exceed 0.50 to minimize financial risk exposure. • Some firms fail however at lower levels. • 2. Leverage ratio: • Total debt divided by equity or net worth. • Often a credit standard in loan approval decisions. • Should not exceed 1.0 to minimize financial risk exposure. • Effects of rising interest rates.

12. Solvency Trends Failed Survived Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

13. Solvency Trends Failed Maximum Survived Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

14. Measures of Profitability • 1. Rate of return on assets: • Net farm income before interest and taxes divided by average • farm assets during the year. • Demonstrates the accrual adjusted pre-tax return to management • total capital invested in the farm operation. • Should be positive; the higher the better.

15. Measures of Profitability • 1. Rate of return on assets: • Net farm income before interest and taxes divided by average • farm assets during the year. • Demonstrates the accrual adjusted pre-tax return to management • total capital invested in the farm operation. • Should be positive; the higher the better. • 2. Operating profit margin ratio: • Net farm income before interest and taxes divided by gross farm • revenue. • Demonstrates accrual adjusted income per dollar of goods sold. • Typically in the 10-30 percent range.

16. Profitability Trends Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

17. Profitability Trends Survived Minimum Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

18. Measure of Debt Repayment Capacity • 1. Term Debt and Capital Lease Coverage Ratio: • Funds available from operations to cover scheduled payments • divided by scheduled principal payments on term loans and • capital leases. • After provision for taxes and withdrawals. • Should be greater than 1.0. • Non-farm income often factored in by lenders.

19. Measure of Debt Repayment Capacity • 1. Term Debt and Capital Lease Coverage Ratio: • Funds available from operations to cover scheduled payments • divided by scheduled principal payments on term loans and • capital leases. • After provision for taxes and withdrawals. • Should be greater than 1.0. • Non-farm income often factored in by lenders. • 2. Capital Replacement and Term Debt Margin: • Funds available from operations to cover scheduled payments • and replace aging equipment and buildings. • After provision for taxes and withdrawals. • Should be positive; the higher the better.

20. Debt Repayment Capacity Survived Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

21. Indicators of growth/survival: Increasing liquidity Increasing solvency Increasing debt repayment capacity Increasing profitability Indicators of potential failure: Declining liquidity Declining solvency Decreasing debt repayment capacity Decreasing profitability Some Conclusions….

22. Tale of Two Cities… Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

23. Tale of Two Cities… Failed Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

24. Tale of Two Cities… Failed Failed Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

25. Tale of Two Cities… Failed Failed Failed Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

26. Historical Analysis • A look backwards like the Beaver study. • Comparison of current performance with past performance. • Recommend doing this at the enterprise level as well as for the farm as a whole.

27. Historical Analysis • A look backwards like the Beaver study. • Comparison of current performance with past performance. • Recommend doing this at the enterprise level as well as for the farm as a whole. • Reasons underlying unwanted trends such as the declines in last two years?

28. Comparative Analysis • Comparing current performance with similar operations like the Beaver study. • Benchmark analysis at enterprise level when possible. Benchmark Your firm

29. Comparative Analysis • Comparing current performance with similar operations like the Beaver study. • Benchmark analysis at enterprise level when possible. • Address reasons why your firm is performing more poorly than other comparable operations before it is too late. Benchmark Your firm

30. Pro Forma Analysis • Stress testing current expected cash flows by varying prices, unit costs and yields. • Look at implications of longer run price and unit cost trends on future financial health when making major decisions.

31. Forces of change…. • Impacts of rising unit costs of production inputs. • Prices, costs and yields can all affect the financial health of the firm. • Failure to account for the risk associated with adverse trends can lead to failure of the firm.

32. Sources of Uncertainty • Global trends in production and consumption • Energy prices and core inflation trends • Interest rates and exchange rates • WTO and the 2007 farm bill

33. Reading the Road Signsin Financial Statements

34. Some Signs Are Confusing…

35. Signs to Avoid…

36. Some signs were hard to read in the 1980s...

37. What we saw when things became clear in the 1980’s

38. Ignoring adverse trends has its consequences….

39. Any Questions?