Thursday, June 10, 2010
What Yardsticks Should Be Used To Measure Your Farm’s Financial Stability?
Your lender may have made some comments earlier this year that still echo. He or she may have warned that your financial numbers were a concern because of declines in profitability, liquidity, or solvency, or maybe more than one of those. You received financing for another year, but the lender said if the trends did not reverse, there may not be another year. You thanked the lender for extending credit for another season, but since you walked out of that office, you have not sure how to make the necessary changes.Financial troubleshooting can be a daunting task, says Robert Jolly, an ag economist and farm finance specialist at Iowa State University. His newsletter in the June edition of the Ag Decision Maker says different problems required different strategies, and while some are simple, most are complex and it is difficult to determine what may have to be done. He says, “Human behavior always complicates the identification and implementation of needed managerial or business changes.” However, he offers an approach to determine what the problem is and how to solve it.
While Jolly does not mention it, one place to begin may be with that lender. Most will be able to identify whether your problems are with profitability, liquidity, or solvency. Profitability is the return to management, labor, and equity after costs are covered. Profit can be measured with an income statement and there are many financial ratios that a lender can share with you to measure profitability. Liquidity is your cash flow, and indicates whether you can meet your cash obligations, such as loan payments and family living expense. It is best measured with a cash flow statement. Solvency is the ability to withstand financial adversity and represents your net worth or owner equity. It can help secure credit and shows the capacity of a business. It is best measured with a balance sheet. You can have a problem in one and not others, however, a continuation will deteriorate the others.
If one of those three has a problem, Jolly says it may have been caused by one of several indicators of success, which are efficiency, scale, and debt structure.
• Efficiency is measured in physical terms, such as yield per acre, or pigs per litter and reflects the relationship between inputs and outputs. While efficiency reflects a level of skill, it will judge the abilities of the owner, as well as the worker. Low efficiency will result in reduced profitability and when you have low returns and high costs, liquidity declines and eventually destroys solvency. While not simple, good farm management skills will be able to improve profitability.
• Scale is the size of your business, and may be too big or too small for your management ability. Measure the scale with the number of jobs on the farm compared to the labor available to do the job. It can be quantified as bushels or head per worker or workers per acre. If there is excess labor, then the funds allocated for family living can hurt the profitability or liquidity. Reduce labor by eliminating employees or increasing the size of the operation.
• Debt structure impacts profitability by forcing it to fund too much interest. It impacts liquidity by giving it too many loan payments to make. And it impacts solvency by restricting the value of assets needed to secure the debt. When debt is too much, then assets have to be sold to reduce liabilities.
Summary:
Troubleshooting financial problems requires a systematic approach and good financial data to evaluate certain ratios which point to problems. Poor financial performance can be caused by several interacting factors, and a resolution of the problem may be unique to a given farm.
Posted by Stu Ellis on 06/10 at 01:27 AM | Permalink