Handout #1
Agricultural Economics
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Handout #1
Spring Semester 2008
John B. Penson, Jr.
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Part I: Review of Concepts and Jargon
A. Introduction to Terminology
Before proceeding with key topics in the financial analysis of an agricultural firm, we
need to refresh your memory on key terminology and introduce you to others.
Liquidity
Liquidity is generally defined as the ability to generate cash quickly to meet claims on the
business without disrupting the ongoing operations of the business. There are three forms
of liquidity: (1) asset liquidity, (2) credit liquidity and (3) cash flow liquidity.
Asset liquidity – the ability to convert assets to cash quickly to meet claims on the
business without disrupting the ongoing operations of the business. If the firm can
convert its current assets to cash, retire its current liabilities and have cash left over, the
firm is said to be liquid. Assets that can be converted to cash quickly are referred to as
current assets, and include financial instruments (cash itself, stocks and bonds and
accounts and notes receivable) as well as non-financial assets like unsold production
inventories and inventories of purchased inputs. Assets on a firm’s balance sheet are
typically ordered in terms of their liquidity, which explains why cash appears first in the
asset column of the balance sheet and land appears last. While land may be sold quickly,
its sale will affect the ongoing nature of the firm’s business operations.
Credit liquidity – the ability to borrow cash quickly to meet claims on the
business without disrupting the ongoing operations of the business. This concept is
related to the firm’s unused credit reserves, or the maximum amount of credit lenders will
typically extend to a firm based upon its debt/equity structure.
Cash flow liquidity – the first two measures of liquidity are typically based upon
balance sheet evaluations at a specific point in time. Cash flow liquidity on the other
hand is a periodic measure of liquidity, usually monthly. The firm’s monthly cash flow
statement reflects the cash flows available and cash flows required during the month. If
the ensuing difference between these totals, or net cash balance, is positive, the firm is
liquid during that month.
Solvency
Solvency refers to the ability of the firm to convert all its assets to cash, retire all of its
liabilities and have cash left over. Note the emphasis on all assets and all liabilities as
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opposed to current assets and current liabilities when we discussed the concept of asset
liquidity described above.
Profitability
Profitability refers to the ability of a firm to generate a level of revenue that exceeds its
total costs of production. The bottom line of the firm’s income statement reflects the net
income of the firm, one of many measures of profitability. Care must be taken when
assessing profitability over time to account for changes in the purchasing power of
money. Nominal net income refers to net income not been adjusted for inflation while
real net income reflects adjustments for changes in the purchasing power of the firm’s
profits from one year to the next.
Economic efficiency
Economic efficiency refers to the ability of the firm to use its resources to achieve a
desired result with little or no wasted effort or expense. This differs from technical
efficiency or productivity (i.e., yield per acre) which does not take prices or unit costs of
production into account.
Debt repayment capacity
Debt repayment capacity refers to the ability of the firm to meet its scheduled term debt
and capital lease payments and have cash left over. This concept is closely linked to the
concept of unused credit reserves in the literature, or the difference between the
maximum capacity to borrow as viewed by lenders and the amount of borrowed capital
the firm has already undertaken.
Present vs. future value
Present value refers to the value today of a sum of money or stream on payments to be
received in the future, discounted back to the present using an appropriate required rate of
return. Future value, on the other hand, refers to the value at a specific future date of a
sum of money or stream of payments (perhaps to an annuity).
Risk
The possible variation associated with the expected return or value measured by the
standard deviation or coefficient of variation. There are many forms of risk, including
price risk, interest rate risk, yield risk, political risk, relationship risk, etc.). This
collectively is often referred to as business risk, or the relative dispersion or variability in
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the firm’s expected earnings. This differs then from financial risk, or the potential loss
in equity associated with the use of leverage (debt and equity capital). Finally, risk can
also be classified as systematic risk (or non-diversifiable risk) and unsystematic risk (the
portion of the variation in investment returns that cannot be eliminated by
diversification).
Physical vs. financial capital
Physical capital refers to those assets on the firm’s balance sheet that are not in the form
of financial instruments. Examples include inventories of unsold production, machinery
and equipment, inventories of production inputs, trucks, buildings and land. Financial
capital, on the other hand, typically refers to financial instruments (cash, stocks and
bonds) as well as the equity capital the owners firm have invested in the firm.
Explicit vs. implicit costs
Explicit costs are those expenses such as wages paid to hired labor where a cash payment
to others is required. Implicit costs on the other hand are those expenses such as
depreciation or opportunity costs that do not involve the payment of money.
Variable vs. fixed expenses
Variable expenses are those expenses that vary with the level of production. Fuel and
fertilizer expenses are two examples. Fixed expenses, on the other hand, are those
expenses that do not vary with the level of production. A property tax payment, which
must be paid even if output of the firm is zero, is a form of fixed expenses.
Optimal capital structure
This refers to the capital structure that maximizes the firm’s composite cost of capital for
a given amount of debt and equity capital. This will be influenced by the relative cost of
financing capital acquisition opportunities with debt and equity capital.
Capital budgeting
The decision making process associated with investment in fixed assets (machinery and
equipment, land and buildings. There are various forms of capital budgeting methods
available, including the payback period method, the profitability index method, the
internal rate of return method and the net present value method. Each will be covered in
depth later in this booklet.
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Financial analysis
Financial analysis refers to the assessment of a firm’s financial performance, both from a
historical perspective and a futuristic perspective. The overall objective is to determine
the firm’s existing financial strengths and weaknesses, and to develop/evaluate strategies
that affect the firm’s future performance. Both perspectives involve the use of financial
ratios as performance indicators as well as decision aides or analytical tools to evaluate
decisions to expand/contract enterprises in the firm.
B. Key Financial Indicators to Track
Measures of liquidity
There are several approaches to measuring the liquidity of a firm depending on whether
you are talking about asset liquidity, credit liquidity or cash flow liquidity.
Two common measures of asset liquidity are the current ratio and the level of working
capital. The current ratio is given by:
(1)
Current ratio = current assets  current liabilities
where current assets are those assets that can be converted to cash within the year and
current liabilities are those liabilities that are due within the year. If this ratio is greater
than 1.0, the firm is said to be liquid, or able to retire all its current liabilities with its
current assets and have cash left over. Studies have shown, however, that the firm can be
liquid and still fail. Other ratios (acid test ratio and cash ratio) represent variations of
equation (1), where specific categories of current assets are excluded from the numerator.
The level of working capital is given by:
(2)
working capital = current assets – current liabilities
If the level of working capital is positive, then the firm has sufficient current assets to
cover all its current liabilities and still have cash left over. This term is sometimes
referred to as net working capital.
Measures of solvency
There are numerous approaches to measuring the solvency of the firm. They all involve
balance sheet data and are transformations of one another. These measures include the
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debt ratio, the net worth ratio, the asset ratio and the leverage ratio. Each is defined as
follows:
(3)
debt ratio = total debt or liabilities  total assets
(4)
net worth ratio = total net worth or equity  total assets
(5)
asset ratio = total assets  total debt or liabilities
(6)
leverage ratio = total debt or liabilities  total net worth or equity
Suppose the firm’s total assets are $100 and its total debt or liabilities are $25. In this
case the firm’s debt ratio would be 0.25, its net worth ratio would be 0.75, its asset ratio
would be 4.0, and its leverage ratio would be 0.33. All ratios indicate this firm would be
solvent; its could convert all of its assets ($100) to cash, retire all of its liabilities ($25),
and still have cash left over ($75).
Measures of profitability
In addition to the level of net income, which we said earlier is a measure of profitability,
other commonly-used measures exist. These include the rate of return on assets (ROA)
and the rate of return on equity capital (ROE). Another measure is the net or operating
profit margin. These measures can be defined as follows:
(7)
Rate of return on assets = (net income + interest expense)  total assets
(8)
Rate of return on equity = net income  total equity or net worth
(9)
Net profit margin = (EBIT – tax)  total revenue
where EBIT represents earnings before interest and tax payments, or net income minus
interest and tax payments. Suppose a firm had the following characteristics: $100 in total
assets, $25 in total debt, total revenue of $200, interest expenses of $5, taxes of $10 and
other expenses totaling $130. The firm’s net income would be $55 (i.e., $200 - $130 $5 - $10) and its EBIT would be $70 (i.e., $55 + $5 +$10). This would result in a ROA
of 60% (i.e., {[$55 + $5]$100}100); an ROE of 73% (i.e., [$55$75] 100), and a net
profit margin of 30% (i.e., {[$70 - $10]  $200} 100).
Measures of economic efficiency
Like the other financial indicators, there are a variety of measures of economic efficiency
used by financial analysts. These include a number of expense ratios (interest expense
ratio, variable expense ratio, depreciation expense ratio) as well as several turnover ratios
(total asset turnover and fixed asset turnover). These ratios are defined as follows:
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(10)
interest expense ratio = interest expenses  total revenue
(11)
variable expense ratio = total variable expenses  total revenue
(12)
depreciation expense ratio = depreciation expenses  total revenue
(13)
total asset turnover ratio = total revenue  total assets
(14)
fixed asset turnover ratio = total revenue  fixed assets
Assume the firm’s depreciation expense is $20 and its total fixed assets are $85. Using
the example discussed with respect to measures of profitability, the firm’s interest
expense ratio would be 2.5% (i.e., [$5$200] 100), its variable expense ratio would be
55% (i.e., {[$130 - $20] $200}100), its depreciation expense ratio would be 10% (i.e.,
[$20$200] 100), its total asset turnover ratio would be 2.0 (i.e., $200$100) and its
fixed asset turnover ratio would be 2.35 (i.e., $200$100). This means the firm’s interest
expenses, variable expenses and depreciation expenses are 2.5%, 55% and 10% of every
dollar of total revenue, respectively. The firm furthermore turns over its total assets twice
each year and fixed assets 2.35 times each year.
Measures of debt repayment capacity
Finally, measures of debt repayment capacity include term debt and capital lease
coverage ratio, times interest earned ratio, and debt burden ratio to name a few. They are
calculated as follows:
(15)
Term debt and capital
lease coverage ratio = (EBIT – taxes)  term debt and capital lease payments
(16)
Times interest earned ratio = (EBIT – taxes)  scheduled interest payments
(17)
Debt burden ratio = total debt outstanding  net income
The financial indicators in equations (15) and (16) should be greater than one. This
would indicate the firm has, at minimum, the capability to service their commitments as
scheduled. Obviously the greater these ratios are, the greater the comfort zone for the
lender. Equation (17) indicated the number of periods needed to retire total debt
outstanding if net income was used entirely for this purpose. If the net income statistic
used comes from an annual income statement, then this ratio would reflect the number of
years necessary to retire the firm’s entire debt. While this may reflect the eventual
application of net income, it does indicate to a lender the firm’s ability to retire debt from
operations.
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C. Financial Strength and Performance of the Firm
Financial analysis was defined earlier as “the assessment of a firm’s financial condition
or well being”. Its objectives were said to be “determine the firm’s financial strengths
and identify its weaknesses”. A number of financial indicators were defined and
interpreted. Nothing however was said about the basis for comparison other than a
specific level so satisfy the definition of liquidity, etc.
Often the most accurate or reveling assessment of a firm’s financial strength and
performance involves assessing the trends in a number of ratios over time and deviations
from the financial achievements of other similar or “like kind” firms. This is called
historical financial analysis and comparative financial analysis.
Historical analysis
Historical financial analysis involves comparing the firm’s current performance with its
performance in previous years, and identifying the underlying reasons for deviations from
expectations. This involves computing the above measures for liquidity, solvency,
profitability, economic efficiency and debt repayment capacity (one measure from each
group should do) for the latest available year (2000) and comparing the values of each
measure with say the Olympic average over the last five years (drop the high and low
when computing the average).
Understanding why any undesirable deviations in liquidity, solvency, profitability and
other categories of financial indicators occurred during the most recent period may help
formulate strategies that prevent further occurrences. There may very well be a good
explanation tied to one-time events beyond the control of the producer. Conducting a
comparative financial analysis with similar firms will help confirm this conclusion
Comparative analysis
As the name suggests, comparative financial analysis involves comparing the financial
strength and performance of the firm with that of similar firms. The current weak
performance of the firm may not be a one-time event beyond the control of the producer,
but rather something similar firms did not experience, at least not to the same degree.1
A study by W. H. Beavers showed that the financial ratios of firms that subsequently fail
are different from those firms that survived.2 Beavers tracked the current ratio, debt ratio,
References to similar or “like kind” firms refers to comparisons with firms of similar size producing the
same products in the same geographical area for the same market structure.
2
W. H. Beavers, “Financial Ratios and Predictors of Failure”, in Empirical Research in Accounting:
Selected Studies, Supplement to Journal of Accounting Research, Volume 66:77-111.
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rate of return on assets, and the reciprocal of the debt burden ratio described earlier in this
booklet (equations (1), (3), (7) and (17) respectively).
Catching undesirable differences from other firms in its peer group early enough to
minimize or eliminate their long-term effects is paramount to the long run success of the
firm. The gap between the successful firms and the firms that failed in the Beavers study
was not that great in the initial year. The growth in the use of borrowed funds to cash
flow operations in subsequent years, however, eventually led to sharp differences
between the successful and failing firms as additional interest expenses grew and ROA
declined.
Summary
The bottom line is that completion of financial statements to meet external reporting
requirements only to then store them in a filing cabinet ignores a rich source of
information on assessing the financial health of the business. Furthermore, calculation of
the various measures described in equations (1) thru (17) in the previous section of this
booklet does not necessarily help matters much. The issue is whether or not the firm’s
performance improved over last year’s results or the Olympic average over the last 5
years. And if not, why? This requires the use of historical financial analysis. In
addition, comparative financial analysis can tell us whether a down trend in these various
performance indicators is something unique to the firm, or is being experienced by other
“like kind” firms as well.