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November 11, 2020

The Ins and Outs of Financial Ratios

Monitoring Farm Sector Ratios Can Improve Operations and Loan Outcomes.

The financial health in the farm sector remains better than historic averages, but there has been an increased need for borrowing as loan demand hit an 11-year-high among farmers and ranchers.

Understanding how agricultural lenders evaluate your operation’s financial records and how industry trends impact your farm’s finances can give you a leg up when it comes to using the right bookkeeping measures to help you secure a loan.

Five Key Financial Conditions that Affect Loan Approval

Guidelines from the Farm Financial Standard Council offer five Farm Sector Financial Ratios, which lenders closely monitor, to measure the financial standing of the agricultural sector and the impact it has on the individual farming operation:

  1. Liquidity – measures how well a farm can pay its debt.
  2. Solvency – calculates how well a farm can pay off all its debt if all assets were liquidated and used to pay debt.
  3. Profitability – is the amount of profit a farm generates through its operations.
  4. Financial efficiency – evaluates how well the farm uses assets to generate revenues and how effective they are at cost control.
  5. Repayment capacity – determines how well the farmer can repay term debt using farm and non-farm income.

Assessing Your Farm’s Financial Health

The USDA’s Economic Research Service (ERS) provides analyses of farm sector income outlook and financial well-being. The data and analyses are used by USDA and industry leaders as a primary indicator of the financial health and economic well-being of the agricultural sector of the U.S. economy.

The data includes historical, state, and national estimates of commodity revenues, expenses, net income, assets, debt, and equity (wealth) as well as forecasts of economic performance for the U.S. farm sector.

Using Ratios to Increase Efficiency

Debt-to-Asset Ratio and Current Ratio are Particularly Important to Agricultural Lenders

Debt-to-Asset Ratio alerts lenders of risk exposure. The greater your debt-to-asset ratio, the greater the level of your financial leverage. Asset values influence the debt-to-asset ratio. For example, if the debt load remains steady, increasing land prices will lower the ratio over time. Debt-to-asset ratios also tend to be higher at the outset of a farm owner’s career. As farm owners have the opportunity to earn a profit over several years, debt repayment lowers the debt-to-asset ratio.

A current ratio greater than one shows positive working capital and the ability to pay off current liabilities, while a current ratio less than one, alerts lenders of negative working capital.

The current ratio varies by the age of the farm operator and follows the increase in working capital; the older the farm operator, the more likely they are to have a greater level of working capital and a higher current ratio. This ratio is also influenced by the type of farming enterprise. For instance, over time, grain farms have shown higher current ratios than hog, dairy, or beef cattle farms. Cash and bank account balances, grain and market livestock in end-of-year inventory, and prepaid expenses are examples of some of the more significant current assets to farming operations.

Bookkeeping and Accounting

Using an accrual basis accounting system enables lenders to see profitability on a month-to-month basis and provides the clarity lenders need to understand your long-term business plan and recognize your ability to meet loan obligations.

Agricultural financial ratios can be an important part of an effective management plan. By calculating and monitoring ratios, farm owners can identify areas where operations can be improved. Ratios can help transform the way a farm operates and increase its operating efficiency to desired levels needed when applying for a loan.

Improve Your Operation’s Financial Health

With our spectrum of land loan programs designed to support U.S. farmers and ranchers from coast to coast, AgAmerica Lending is here to help you understand and navigate the lending process. Contact us today to speak with one of our loan specialists about how we can help sustain or grow your operation.

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