Financial Check Up

Agribusiness FinanceLESE 306 Fall 2009

Seen the Doc Lately? Benefits from an

annual financialfinancial checkup.

Treadmill stress test your financialfinancial strength.

Get your visionvision examined.

What is the status of your…. Liquidity? Solvency? Profitability? Efficiency? Debt

repayment capacity?

Survivability?

Key Financial Indicators

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 ratioCurrent 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 1.0exceed 1.0 to be technically liquid.• Some firms fail despite exceeding this hurdle.

Measures of Liquidity

1. Current ratioCurrent 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 1.0exceed 1.0 to be technically liquid.• Some firms fail despite exceeding this hurdle.

2. Working capitalWorking capital:• Current assets minus current liabilities.• Expresses liquidity in dollars rather than ratio.• Should be positive.• Cash is King!Cash is King!

Liquidity TrendsCurrent Ratio

0.00

0.501.00

1.50

2.00

2.503.00

3.50

4.00

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity TrendsCurrent Ratio

0.00

0.501.00

1.50

2.00

2.503.00

3.50

4.00

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MinimumMinimum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity Trends

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measures of Solvency

1. Debt ratioDebt 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 0.50not exceed 0.50 to minimize financial risk exposure.• Some firms fail however at lower levels.

Measures of Solvency

1. Debt ratioDebt 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 0.50not exceed 0.50 to minimize financial risk exposure.• Some firms fail however at lower levels.

2. Leverage ratioLeverage ratio:• Total debt divided by equity or net worth.• Often a credit standard in loan approval decisions.• Should not exceed 1.0not exceed 1.0 to minimize financial risk exposure.• Effects of rising interest rates.

Solvency Trends

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Solvency Trends

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MaximumMaximum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measures of Profitability

1. Rate of return on assetsRate 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 positivepositive; the higher the better.

Measures of Profitability

1. Rate of return on assetsRate 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 positivepositive; the higher the better.

2. Rate of return on equityRate of return on equity:• Net income divided equity.• Demonstrates the after-tax return on owner equity invested in the firm.• Should be positivepositive; the higher the better.

Profitability TrendsRate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Profitability TrendsRate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MinimumMinimum

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 RatioTerm 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 1.0greater than 1.0. • Non-farm income often factored in by lenders.

Measure of Debt Repayment Capacity

1. Term Debt and Capital Lease Coverage RatioTerm 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 1.0greater than 1.0. • Non-farm income often factored in by lenders.

2. Debt Burden RatioDebt 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 lowlow; the lower the better.

Debt Repayment Capacity

Net Cash Income-to-Total Debt

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Inverse of debt burden ratio

assuming use of depreciation

allowances to retire debt.

Inverse of debt burden ratio

assuming use of depreciation

allowances to retire debt.

Some Conclusions…. Indicators of Indicators of

growth/survival:growth/survival: Increasing liquidity Increasing solvency Increasing debt

repayment capacity Increasing

profitability

Some Conclusions…. Indicators of Indicators of

potential potential failure:failure: Declining liquidity Declining solvency Decreasing debt

repayment capacity

Decreasing profitability

Some Conclusions…. Indicators of Indicators of

growth/survival:growth/survival: Increasing liquidity Increasing solvency Increasing debt

repayment capacity Increasing

profitability

Indicators of Indicators of potential potential failure:failure: Declining liquidity Declining solvency Decreasing debt

repayment capacity

Decreasing profitability

Tale of Two Cities…Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Tale of Two Cities…Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Tale of Two Cities…

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Tale of Two Cities…

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

Net Cash Income-to-Total Debt

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1 2 3 4 5

Year Before Failure

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Multiple Uses of Financial Indicators

#1: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.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

1 2 3 4 5

Prior Years

#1: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.

Why is ROA falling?Why is ROA falling?

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

1 2 3 4 5

Prior Years

#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

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

#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 before it is too lateis too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

#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 before it is too lateis too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

#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 before it is too lateis too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

#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 before it is too lateis too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

#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 before it is too lateis too late.

#3:Pro Forma Analysis Stress testingStress 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 future financial healthhealth when making major decisions.

Sources of Uncertainty Global trends in

production and consumption

Energy prices and core inflation trends

Interest rates and exchange rates

Changes in industry subsidies

Reading the Road Signsin Financial Management

Pro Forma AnalysisPro 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….