Financial Statement Analysis. Understanding and Using Financial Ratios

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1 Financial Statement Analysis Understanding and Using Financial Ratios

2 2 Introduction The four financial statements contain much of the information need to make business decisions How can this information be used to analyze a farm or a business? Decision making can be improved through financial planning in five ways Identify and learn from past mistakes Make fewer mistakes Take timely and appropriate action to correct mistakes that are made Identify strengths and weaknesses Spot opportunities

3 3 9/17/2013 Analyzing Financial Position and Performance Techniques For Analysis Financial Statements Trends Cost vs. Market Asset vs. Debt Structure Cash vs. Accrual Pro Forma Analysis What if Commodity and Weather Cycles Breakeven

4 4 9/17/2013 Analyzing Financial Position and Performance Monitoring and Control Projected vs. Actual Variance Analysis Operations and plan adjustments Ratio Analysis Standards Ranges Trend (direction and slope) Historical variability Projected vs. Historical Average Sensitivity Analysis Interrelationships (DuPont Model)

5 5 Ratio Analysis Three standards of comparison for ratios Compare the business against itself Past performance to present Present performance to budgeted performance Able to identify trends Compare the business to a set of benchmarks Benchmarks must be first determined (e.g. Peer Groups) Compare the business to an average or quartiles for firms of similar size and type Regional databases, ag lenders, ag accounting firms

6 6 Notes of Caution Apples to Apples Income calculation Before or after tax Cash or accrual Business only or combination of business and personal Business organization form Balance Sheet Cost basis valuation or market based Business only or combination of business and personal Deferred taxes included or not

7 7 Financial Measures Five criteria Liquidity Solvency Profitability Repayment capacity Financial efficiency All measure financial position or financial performance

8 8 Liquidity Measures Liquidity ratios Measures the ability of the farm business to meet financial obligations as they come due, without disrupting the normal, ongoing operations of the business Analyzed two ways Structural liquidity Balance sheet measures Relationship between assets and liabilities Operational liquidity Cash flow measures

9 9 Liquidity Measures Working Capital Measure of the amount of funds that would be available to purchase inputs after the sale of current farm assets and payment of all current farm liabilities Equation Working Capital = Current Farm Current Farm Liabilities

10 10 Issues of Working Capital Absolute dollar amount Difficult to make comparisons between businesses Unable to establish one standard Dependent upon size of firm Future projections Reflects amount at one point in time Does not reflect timing of future cash flows

11 11 Current Ratio Used to evaluate the relationship between total current farm assets and total current farm liabilities Equation Current Farm / Current Farm Liabilities

12 12 Current Ratio Relative measure Higher the ratio, the more liquid the business Acceptable values vary with business type Not dependent on size of firm, can be used for comparisons

13 13 9/17/2013 Working Capital to Gross Revenues FFSC found it to be more useful than the current ratio Equation Working Capital/Gross Farm Income

14 14 Cash Flow Coverage Ratio Assesses the business s ability to meet cash obligations Calculated from the cash flow statement Equation Cash Available/ Cash Required

15 15 Cash Flow Coverage Ratio The higher the ratio, the higher the liquidity Can be used for scenario analysis

16 16 9/17/2013 Budgeting Error Equation [(Actual Cash Available Actual Cash Required) (Projected Cash Available Projected Cash Required)] (Projected Cash Available Projected Cash Required) X 100

17 17 9/17/2013 Solvency Measures the amount of borrowed capital or debt, leasing commitments and other expense obligations relative to the amount of owner s equity invested in the business. Solvency measures provide an indication of the firm s ability to repay all financial obligations if all assets were sold, and an indication of the ability to continue operations as a viable business after a financial adversity.

18 18 Solvency Measures Concerned with long-term as well as short-term assets and liabilities Evaluates what would happen if all assets were sold and converted to cash and all liabilities were paid Indicates the business s ability to withstand risks and to continue operations after financial adversity The most straightforward measure Owner equity Difficult to measure Depends on size of firm

19 19 Solvency Measures Debt to Asset Debt to Equity Equity to Asset All three are equivalent because they use 2 of the 3 parts of the balance sheet identity equation, TA = TL OE. If you know any two of the variables, you can determine the third.

20 20 Debt to Asset Ratio Expresses total farm liabilities as a proportion of total farm assets One way to express financial risk exposure If the ratio is more than.5:1 the creditors have more money in the business than the owners Equation Farm Liabilities/ Farm

21 21 Debt to Asset Ratio Three main issues Greatly influenced by the value placed on farm assets Market based Cost based Impact of deferred taxes Reasonable standard will vary from one type of enterprise to another No single standard Depends on how debt is being used

22 22 Debt to Equity Ratio Reflects the extent to which farm debt is being combined with farm equity capital Often called the leverage ratio, but all the solvency measures are measures of leverage If the ratio is than 1:1 the creditors have money in the business than the owner Equation Farm Liabilities/ Farm Equity

23 23 Equity to Asset Ratio Expresses the proportion of total assets financed by the owner s equity capital Also called percent ownership Mirror image of debt to asset ratio If the ratio is more than.5:1 the owners have more money in the business than the creditors Equation Farm Equity/ Farm

24 24 Profitability Measures Measures the extent to which a business generates profit from the use of labor, management, and capital Relationship between revenues and expenses Net Farm Income Represents the returns to the farm for unpaid operator and family labor, management and owner s equity. Absolute dollar amount Difficult to make comparisons Before tax amount Organizational form

25 25 Return on Farm (ROA) Used an overall index of profitability Most meaningful for comparisons Equation (Net Farm Income From Operations Farm Interest Expenses Family Living Withdrawals) / Average Farm

26 26 9/13/3013 ROA Issues Family withdrawals Realized and unrealized capital gains are not included May distort the ratio Method of valuation Pre-tax basis Non-farm assets should be excluded

27 27 Rate of Return on Farm Equity (ROE) Measures the rate of return on the owner s equity in the farm business Differs from ROA because ROA considers both owned and borrowed capital Equation (Net Farm Income From Operations Family Living Withdrawals) / Average Farm Equity

28 28 ROE Issues Same as ROA Higher the ratio, the more profitable the business If ROE is than ROA (ROE/ROA is called the power ratio) Business is paying more interest on borrowed money than is being earned

29 29 Operating Profit Margin Ratio Measures the returns to capital per dollar of gross revenue Two ways to increase profit Increase profit per unit produced Increasing the volume of production This ratio is concerned with the first Equation (Net Farm Income From Operations Farm Interest Expense) / Gross Farm Income

30 30 9/17/2013 EBITDA Equation Net Farm Income (pre-tax) Farm Interest Expense Depreciation & Amortization

31 31 Repayment Capacity Measures the ability to repay debt from both farm and non-farm income Evaluates the capacity of the business to service additional debt

32 32 9/17/2013 Capital Debt Repayment Capacity Equation Net Farm Income Depreciation Net Non-Farm Income Interest on Term Loans Family Living Withdrawals & Income Taxes

33 33 9/17/2013 Capital Debt Repayment Margin Equation Capital Debt Repayment Capacity Scheduled Principal & Interest on Term Loans (includes payments on capital leases)

34 34 Debt to Income Ratio Measures the amount by which total debt exceeds annual income Recognizes that equity is not the only thing a borrower can leverage Useful for tracking the overall financial health of the farm sector. Equation Farm Liabilities/Net Farm Income

35 35 9/17/2013 Term-Debt Coverage Ratio Equation Capital Debt Repayment Capacity/Scheduled Principal & Interest on Term Loans (includes payments on capital leases)

36 36 Financial Efficiency Measures Measures the intensity with which a business uses its assets to generate gross revenues and the effectiveness of production, purchasing, pricing, and financing, and marketing decisions.

37 37 9/17/2013 Equations Asset Turnover Rate Gross Farm Income/Average Farm Operating Profit Margin X Asset Turnover = ROA Operating Expense Ratio ( Farm Operating Expenses Farm Interest & Depreciation) / Gross Farm Income Depreciation Expense Ratio Depreciation/Gross Farm Income Interest Expense Ratio Farm Interest Expense/Gross Farm Income Net Farm Income From Operations Ratio Net Farm Income From Operations/Gross Farm Income

38 38 9/17/2013 Other Measures Average Collection Period Accounts Receivable / (Annual Credit Sales 360) Average Days Payable Accounts Payable / (Annual Credit Purchases 360) Days Inventory Inventory/(Annual Cost of Goods Sold 360) Inventory Turnover Gross Sales/Average Inventory

39 39 9/17/2013 Other Measures Labor Productivity (Labor & Salary Expenses Family Living Withdrawals) / Gross Farm Income (Labor & Salary Expenses Family Living Withdrawals) / Tillable Acres Machinery & Equipment Productivity Machine & Equipment Expenses (including depreciation) / Gross Farm Income Machinery & Equipment Expenses (including depreciation) / Tillable Acres

40 40 9/17/2013 DuPont Analysis ROE = [ ROA - Interest [ Equity ROE = [ Income Gross Revenue Gross Revenue - Interest [ Equity Profit Margin Asset Turnover Interest Cost Leverage

41 41 DuPont Model Sales Gross Margin COGS Gross Profit Operating Expense Expense Percent Operating Profit Federal Taxes After-tax Profit Divided by Sales Net Profit Margin Inventory Turnover Age of Accts. Rec. Inventory Accts Receivable Cash Current Fixed Current Liab. Long-term Liab. Sales Divided by Liab. X Asset Turnover Divided by Net Worth Return on X Financial Leverage Return on Equity

42 DuPont Model Base Sales $1,345,803 COGS $878,633 Inventory Turnover 1.61 Age of Accts. Rec. 55 Gross Margin 35% Gross Profit $467,170 Operating Expense $392,924 Expense Percent 29% Inventory $833,393 Accts Receivable $202,085 Cash $35,502 Operating Profit $74,246 Federal Taxes $0 Current $1,070,980 Fixed $464,323 Current Liab. $69,406 Long-term Liab. $266,970 After-tax Profit $74,246 Divided by Sales $1,345,803 Sales $1,345,803 Divided by $1,535,303 $1,535,303 Liab. $336,376 Net Profit Margin 5.52% X Asset Turnover 0.88 $1,535,303 Divided by Net Worth $1,198,927 Return on 4.84% X Financial Leverage 1.28 Return on Equity 6.19% 42

43 Increase Gross Margin by 2% Sales $1,345,803 COGS $878,633 Inventory Turnover 1.61 Age of Accts. Rec. 55 Gross Margin 37% Gross Profit $467,945 Operating Expense $392,924 Expense Percent 29% Inventory $833,393 Accts Receivable $202,085 Cash $35,502 Operating Profit $105,021 Federal Taxes $0 Current $1,070,980 Fixed $464,323 Current Liab. $69,406 Long-term Liab. $266,970 After-tax Profit $105,021 Divided by Sales $1,345,803 Sales $1,345,803 Divided by $1,535,303 $1,535,303 Liab. $336,376 Net Profit Margin 7.80% X Asset Turnover 0.88 $1,535,303 Divided by Net Worth $1,198,927 Return on 6.84% X Financial Leverage 1.28 Return on Equity 8.76% 43

44 Cut Overhead Expense as a Percent of Sales by 3% Sales $1,345,803 COGS $878,633 Inventory Turnover 1.61 Age of Accts. Rec. 55 Gross Margin 34.71% Gross Profit $467,170 Operating Expense $349,909 Expense Percent 26% Inventory $833,393 Accts Receivable $202,085 Cash $35,502 Operating Profit $117,261 Federal Taxes $0 Current $1,070,980 Fixed $464,323 Current Liab. $69,406 Long-term Liab. $266,970 After-tax Profit $117,261 Divided by Sales $1,345,803 Sales $1,345,803 Divided by $1,535,303 $1,535,303 Liab. $336,376 Net Profit Margin 8.71% X Asset Turnover 0.88 $1,535,303 Divided by Net Worth $1,198,927 Return on 7.64% X Financial Leverage 1.28 Return on Equity 9.78% 44

45 Increase Inventory Turns By 1 Sales $1,345,803 COGS $878,633 Inventory Turnover 2.60 Age of Accts. Rec. 55 Gross Margin 34.71% Gross Profit $467,170 Operating Expense $392,924 Expense Percent 29.20% Inventory $517,616 Accts Receivable $202,085 Cash $35,502 Operating Profit $74,246 Federal Taxes $0 Current $755,203 Fixed $464,323 Current Liab. $69,406 Long-term Liab. $266,970 After-tax Profit $74,246 Divided by Sales $1,345,803 Sales $1,345,803 Divided by $1,219,526 $1,219,526 Liab. $336,376 Net Profit Margin 5.52% X Asset Turnover 1.10 $1,219,526 Divided by Net Worth $883,150 Return on 6.09% X Financial Leverage 1.38 Return on Equity 8.41% 45

46 Reduce Receivables To 30 Days Sales $1,345,803 COGS $878,633 Inventory Turnover 1.61 Age of Accts. Rec. 30 Gross Margin 34.71% Gross Profit $467,170 Operating Expense $392,924 Expense Percent 29.20% Inventory $833,393 Accts Receivable $110,614 Cash $35,502 Operating Profit $74,246 Federal Taxes $0 Current $979,509 Fixed $464,323 Current Liab. $69,406 Long-term Liab. $266,970 After-tax Profit $74,246 Divided by Sales $1,345,803 Sales $1,345,803 Divided by $1,443,832 $1,443,832 Liab. $336,376 Net Profit Margin 5.52% X Asset Turnover 0.93 $1,443,832 Divided by Net Worth $1,107,456 Return on 5.14% X Financial Leverage 1.30 Return on Equity 6.70% 46

47 Combined Effects Sales $1,345,803 COGS $878,633 Inventory Turnover 2.60 Age of Accts. Rec. 30 Gross Margin 37% Gross Profit $497,947 Operating Expense $349,909 Expense Percent 26% Inventory $517,616 Accts Receivable $110,614 Cash $35,502 Operating Profit $148,038 Federal Taxes $0 Current $663,732 Fixed $464,323 Current Liab. $69,406 Long-term Liab. $266,970 Increase Gross Margin 2% Cut Overhead by 3% Increase Inventory Turns by 1 Reduce Age of Accts. Rec. to 30 days After-tax Profit $148,038 Divided by Sales $1,345,803 Sales $1,345,803 Divided by $1,128,055 $1,128,055 Liab. $336,376 Net Profit Margin 11% X Asset Turnover 1.19 $1,128,055 Divided by Net Worth $791,679 Return on 13.12% X Financial Leverage 1.42 Return on Equity 18.70% 47

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