As a young farmer or beginning farmer, you will find that there are many ways to prepare for the financial aspects of owning a farm. Working with a farm lender like Farm Credit early on is my first recommendation to make sure your business is understood and the cyclical nature of the industry is taken into account.
The five key financial metrics below are used by most lenders in the loan approval process. These metrics should be used regularly by farm and business owners to measure the success of their business.
1. Equity: It measures the financial situation and the overall indebtedness of the borrower. An equity ratio will tell you what you would end up with if you sold everything you have today and pay off all your obligations. A 100% means that you owe no one and that you can keep all of the proceeds from the sale of your assets.
2. Liquidity: It measures a farm’s ability to meet its financial obligations in the normal course of business (a year of growth) without seriously disrupting the normal operations of the business. Current assets are cash or other farm assets that will be sold in a year. Examples include corn, steers, hay, and fruits and vegetables. More “liquid†assets are easier to sell.
An example of a current liability would be loan payments due over the next 12 months and your line of credit balance. The higher liquidity would indicate the ability of an operation to pay its due bills over the next 12 months.
3. Profitability: This is the amount earned after subtracting cost of goods sold and operating expenses. This indicates the ability of a business to generate profits from normal operations before financing costs, owner’s drawdowns, and living expenses.
4. Efficiency: Ultimately, it is about the use of assets to generate gross income. We look at this in two ways:
- Business efficiency: like controlling costs – what percentage of income is spent on expenses? Are the costs in line with the specific industry? This also includes the asset turnover ratio, which measures the efficiency with which assets generate revenue for the business. The higher the number, the better, as it indicates how efficiently the assets or money you have invested generate income. It is a problem if the value of land continues to rise, but farm income remains stagnant or even decreases.
- Operational efficiency: performance and production numbers and metrics.
5. Repayment capacity: It measures the applicant’s ability to repay and what cushion there is for adversity. The higher the better. Often times this takes the form of a “coverage ratio†and the cushion will be after all loan payments including farm and non-farm loans, taxes and living expenses are paid.
It is common to have capital and liquidity exceptions for a start-up, given that they fund a large majority of asset purchases. Additionally, I see poor profitability and efficiency measures in older farms that don’t invest in the right assets to generate the most farm income.
I can’t underestimate how important it is to have a solid understanding of your business using these five key financial metrics.
If you are ready to start farming or improve your farm’s financial success, contact our team today at 888-339-3334 or visit mafc.com.
No matter what stage you are in the process, we are ready to be your partner.
