Financial ratios serve three main purposes: they provide a quick assessment of a business’s financial health, they’re a tool for diagnosing financial problems if they exist, and they serve as a measurement for assessing whether problems are being solved.
“They show you where you’ve been, they show you where you have a problem and they show you whether or not you’re correcting the problem,” explains Larry Martin, principal in Agri-Food Management Excellence and former chair of the Department of Agricultural Economics and Business at the University of Guelph, in episode 10 of the “Mind Your Farm Business” series.
There are six main ratios that he says tell a farm’s story: “None of them are unique for agriculture, but the benchmarks on some of them are unique for agriculture.”
1.) The current ratio — current assets divided by current liabilities — will tell you if a farm has a short-term problem.
2.) Return-on-equity indicates whether a business has been a good investment over a much longer term.
3.) Gross margin ratio — (gross revenue minus your cost of goods sold eg. seed, fertilizer, chemicals, and so on) divided by gross revenue.
“What we find for grain farms and a lot of livestock operations, that ratio should be around 65 percent or more. If it’s way less than 50 percent, you’re having some problem with your yield, your paying too much for your inputs, or you’re not getting enough of your outputs,” explains Martin.
4.) Contribution margin ratio factors in operating expenses (labour costs, cost of operating machinery, land rent). He explains these operating costs should be in the neighbourhood of 15 to 20 percent of gross revenue, or lower.
5.) Operating efficiency ratio — operating income or EBITDA (earnings before interest, taxes, depreciation and amortization) divided by gross operating revenue.
“For most farms, we expect that if they’re really good they’ll be in the 35 percent range or higher. That’s actually the one I look at first. If that ratio is in the 15 to 20 percent range, I know there’s a problem someplace in your operation,” says Martin.
6.) Rather than using a debt-to-equity ratio, where for example, rising land values might mask an operating problem, he suggests following debt-to-operating earnings (or EBITDA). In other businesses, lenders prefer if this ratio isn’t higher than 2 or 2.5 to 1, but Martin says the average in Canadian agriculture is about 5 to 1.
“The bankers are willing to go with it being higher in Canada for a number of reasons, and I’m okay with that, but when I see someone come in with a 16 to 1 ratio…that’s a little bit highly-leveraged,” he says.
These six ratios, the last four in particular, help with not only noticing a problem, but with drilling down to determine what the problem is — are land rent rates too high? Should the farm being growing a different crop? What needs to change?
There are also other ratios that provide more specific management information, like whether a new piece of land or equipment is worth purchasing. That’s where internal rate of return (IRR) numbers are helpful.
“You use it to evaluate whether to make an investment, and then use it after to figure out if your investment really paid,” explains Martin. “It’s about managing assets, a very specific thing.”
Finally, how often should financial statements and ratios be assessed given the seasonality of cash flow in farming?
It depends on the size and type of farm, he notes, but he recommends tracking numbers on a monthly basis for livestock operations and a quarterly basis in grain farming.
“I can’t imagine having anything beyond quarterly for almost any business,” he says.
Check out the episode above for more with Larry Martin on putting ratios to work, and then head on over to Episode 11 where Moe Russell discusses ratios to “Bootstrap Your Balance Sheet.”
Disclaimer: Royal Bank of Canada and its subsidiaries are not responsible for the information provided in this podcast, and this information does not necessarily reflect the views of Royal Bank of Canada or any of its subsidiaries. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by Royal Bank of Canada or any of its subsidiaries.