Comparing numbers for financial health
by Courtney Llewellyn
Maybe you think you’re doing okay. Maybe you’re struggling to make ends meet. Maybe you’re planning for retirement. There are many different money goals, but the key to achieving them lies in the ability to accurately assess your financial health.
Alex White, Ph.D., instructor in the Department of Dairy Science at Virginia Tech, presented “Assessing Your Financial Health & Analyzing the Financials of New Ventures” at this year’s NAFDMA Convention. His research centers on retirement planning strategies for ag producers and small business owners.
White began his talk by defining some financial health indicators all business owners should know:
- Liquidity – how much cash we have without hurting our productive capability
- Solvency – what percentage of your business is being paid for out of pocket
- Repayment ability/capacity – how do you generate enough cash for life and debts?
- Profitability – which is separate from your bank account getting bigger
- Financial efficiency – in agriculture, it takes 80 to 85 cents to make a dollar
If you know the numbers for the first four items on that list, you’re already in better shape than many. And if you have those numbers, it will help you figure out your financial efficiency, which is a key piece of information if you need to take out another loan for a large purchase.
Before you do anything else, however, you need to start with a balance sheet. In its simplest terms, this document will list what you own, paid for by either your money (which results in equity) or paid for with someone else’s money (such as a loan, which results in a liability). When putting together your balance sheet and tallying up what you own, it’s important to use Doc White’s bird poop principle: If it has bird poop on it, get rid of it. It’s an idle asset.
A balance sheet will also help create a picture of what your business looks like on any one given day – and it’s good to use the same day every year for comparisons. According to White, for a new small business, you’ll want to start with breaking even/making a profit by year 3. If you don’t achieve that goal, you may need to rethink and restructure your business.
Ratios for Financial Health
White noted key financial ratios you can use to identify the financial strengths and weaknesses or your entire operation. A ratio is simply the relationship between two amounts showing the number of times one value is contained within the other; in this case, you want to look at assets versus debt.
For liquidity, a higher ratio is better. Farm businesses should aim for a ratio greater than 1.5 to 2.0, and 1.0 is the bare minimum. That would mean just breaking even. With liquidity, you should also aim for three months of business costs set aside in savings (versus the general three to six months for household expenses).
For working capital and expenses, a ratio of greater than 25% is great and less than 15% is bad. With solvency, higher is better.
Obviously, with repayment capacity, higher is better as well. “Show lenders you’re proactive with the steps you’re taking to bolster your weak areas,” White said. Interest rates are based on the risk you present to the lender. If you have proof your business is in good shape, you’re likely to get better rates.
You want your profitability to be greater than the rate of inflation. (The current inflation rate is 7.87%; last year, it was 1.68%. The long-term average is 3.24%.) This impacts your return on assets (ROA), which refers to a financial ratio that indicates how profitable a company is in relation to its total assets. It’s found by dividing your net income by the worth of your total assets. Note: Your ROA will naturally be higher if you’re leasing a lot of land or equipment – but that’s not necessarily a bad thing.
When looking over your financial records and you notice your financial efficiency drop, that’s not necessarily a bad thing either. You just need to figure out if your income decreased or your expenses increased. Once you have that information, you can adjust your business plan accordingly.
White also noted that the Risk Management Association (rmahq.org) and Standard and Poor’s (spglobal.com) have annual benchmarks for all industries, including many sectors of agriculture, so you can track your numbers against industry averages to see how you’ve been stacking up.
The post Comparing numbers for financial health appeared first on Country Folks.