Financial Check Up
Agribusiness Finance
LESE 306 Fall 2009
Seen the Doc Lately?
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Benefits from an
annual financial
checkup.
Treadmill stress
test your financial
strength.
Get your vision
examined.
What is the status of
your….
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Liquidity?
Solvency?
Profitability?
Efficiency?
Debt repayment
capacity?
Survivability?
Key Financial Indicators
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
Generally accepted Financial
Indicators
Focus today on a few key indicators
of liquidity, solvency, profitability,
financial efficiency, debt repayment
capacity and the implications for
survivability.
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.
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!
Liquidity Trends
Current Ratio
Survived
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Failed
1
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Liquidity Trends
Current Ratio
Survived
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Failed
Minimum
1
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Liquidity Trends
Working Capital-to-Total Assets
Survived
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
Failed
1
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Measures of Solvency
1. Debt ratio:
• Total debt divided by total assets.
• 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.
Measures of Solvency
1. Debt ratio:
• Total debt divided by total assets.
• 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.
Solvency Trends
Total Debt-to-Total Assets
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Failed
Survived
1
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Solvency Trends
Total Debt-to-Total Assets
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Failed
Maximum
Survived
1
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Measures of Profitability
1. Rate of return on assets:
• Net income plus interest divided by total assets.
• Demonstrates the after-tax return to the total capital invested
in the firm.
• Should be positive; the higher the better.
Measures of Profitability
1. Rate of return on assets:
• Net income plus interest divided by total assets.
• Demonstrates the after-tax return to the total capital invested
in the firm.
• Should be positive; the higher the better.
2. Rate of return on equity:
• Net income divided equity.
• Demonstrates the after-tax return on owner equity invested
in the firm.
• Should be positive; the higher the better.
Profitability Trends
Rate of Return on Assets
0.15
0.10
Survived
0.05
0.00
-0.05 1
2
3
4
5
-0.10
-0.15
Failed
-0.20
-0.25
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Profitability Trends
Rate of Return on Assets
0.15
0.10
Survived
0.05
Minimum
0.00
-0.05 1
2
3
4
5
-0.10
-0.15
Failed
-0.20
-0.25
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Measure of Debt
Repayment Capacity
1. Term Debt and Capital Lease Coverage Ratio:
• Cash available from operations to cover scheduled payments
(net income plus depreciation and interest payments less
withdrawals) divided by scheduled principal and interest
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.
Measure of Debt
Repayment Capacity
1. Term Debt and Capital Lease Coverage Ratio:
• Cash available from operations to cover scheduled payments
(net income plus depreciation and interest payments less
withdrawals) divided by scheduled principal and interest
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. Debt Burden Ratio:
• Total debt outstanding divided by net income.
• Number of years required to retire total debt if net income
remains constant and used entirely for this purpose
• Should be low; the lower the better.
Debt Repayment Capacity
Inverse of debt
burden ratio
assuming use of
depreciation
allowances to
retire debt.
Net Cash Income-to-Total Debt
0.60
Survived
0.50
0.40
0.30
0.20
0.10
0.00
-0.10 1
-0.20
2
3
4
5
Failed
-0.30
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Some Conclusions….
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Indicators of
growth/survival:
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Increasing liquidity
Increasing solvency
Increasing debt
repayment capacity
Increasing
profitability
Some Conclusions….
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Indicators of
potential failure:
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Declining liquidity
Declining solvency
Decreasing debt
repayment capacity
Decreasing
profitability
Some Conclusions….
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Indicators of
growth/survival:
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Increasing liquidity
Increasing solvency
Increasing debt
repayment capacity
Increasing
profitability
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Indicators of
potential failure:
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Declining liquidity
Declining solvency
Decreasing debt
repayment capacity
Decreasing
profitability
Tale of Two Cities…
Working Capital-to-Total Assets
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
Failed
1
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Tale of Two Cities…
Total Debt-to-Total Assets
Working Capital-to-Total Assets
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Failed
1
2
3
Year Before Failure
4
5
Failed
1
2
3
4
5
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Tale of Two Cities…
Total Debt-to-Total Assets
Working Capital-to-Total Assets
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Failed
1
2
3
4
5
Failed
1
2
3
4
5
Year Before Failure
Year Before Failure
Rate of Return on Assets
0.15
0.10
0.05
0.00
-0.05 1
2
3
4
5
-0.10
-0.15
-0.20
Failed
-0.25
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Tale of Two Cities…
Total Debt-to-Total Assets
Working Capital-to-Total Assets
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Failed
1
2
3
4
Failed
1
5
2
5
Net Cash Income-to-Total Debt
Rate of Return on Assets
0.15
0.60
0.10
0.50
0.05
0.40
0.30
0.00
2
3
-0.10
4
5
0.20
0.10
0.00
-0.15
-0.20
4
Year Before Failure
Year Before Failure
-0.05 1
3
-0.10 1
-0.20
Failed
-0.30
-0.25
Year Before Failure
2
3
4
5
Failed
Year Before Failure
Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research
Multiple Uses of Financial
Indicators
#1:Historical Analysis
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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.
Rate of Return on Assets
0.10
0.05
0.00
-0.05
1
2
3
-0.10
-0.15
-0.20
-0.25
Prior Years
4
5
#1:Historical Analysis
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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.
Why is ROA falling?
Rate of Return on Assets
0.10
0.05
0.00
-0.05
1
2
3
-0.10
-0.15
-0.20
-0.25
Prior Years
4
5
#2:Comparative Analysis
 Comparing current
performance with
similar operations like
the Beaver study.
 Benchmark analysis at
enterprise level when
possible.
Rate of Return on Assets
0.15
Benchmark
0.10
0.05
0.00
-0.05
-0.10
1
2
3
Your firm
-0.15
-0.20
-0.25
Prior Years
4
5
#2: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.
Rate of Return on Assets
0.15
Benchmark
0.10
0.05
0.00
-0.05
-0.10
1
2
3
Your firm
-0.15
-0.20
-0.25
Prior Years
4
5
#2:Comparative Analysis
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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.
Rate of Return on Assets
0.15
0.10
0.05
0.00
-0.05
1
2
3
-0.10
-0.15
-0.20
-0.25
Prior Years
4
5
#2: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.
Rate of Return on Assets
0.15
0.10
0.05
0.00
-0.05
1
2
3
-0.10
-0.15
-0.20
-0.25
Prior Years
4
5
#2: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.
Rate of Return on Assets
0.15
0.10
0.05
0.00
-0.05
1
2
3
-0.10
-0.15
-0.20
-0.25
Prior Years
4
5
#2: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.
Rate of Return on Assets
0.15
0.10
0.05
0.00
-0.05
1
2
3
-0.10
-0.15
-0.20
-0.25
Prior Years
4
5
#3:Pro Forma Analysis
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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.
Sources of Uncertainty
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Global trends in
production and
consumption
Energy prices and
core inflation trends
Interest rates and
exchange rates
Changes in industry
subsidies
Reading
the
Signs
What PV
is Road
designed
to do...
in
Financial Management
 Demonstrate future consequences
of existing and alternative
concentrations
 Assess key external factors in
strategic planning
 Facilitate proactive as opposed
to reactive management
 Provide minimum 3-year pro
forma financials required in
Business Plan (FCA Reg. 12)
Will export
demand improve?
Pro Forma Analysis
When going
down the road,
use the
windshield as
well as the rear
view mirror!
Some Signs Are Confusing…
Some Signs are Hard to
Read...
Ignoring Adverse Trends
has its Consequences….