Financial Check Up

1
Financial Check Up

• John B. Penson, Jr.
• Regents Professor and
• Stiles Professor of Agriculture
• Texas AM University

2
Seen the Doc Lately?

• Benefits from an annual financial checkup.
• Treadmill stress test your financial strength.
• Get your vision examined.

3
What is the status of your.

• Liquidity?
• Solvency?
• Profitability?
• Efficiency?
• Debt repayment capacity?
• Survivability?

4
Key Financial Indicators

• Sweet 16 Financial Indicators
• Farm Financial Standards Council
• www.ffsc.org
• Focus today on a few key indicators of liquidity,
  solvency, profitability, financial efficiency,
  debt repayment capacity and the implications for
  survivability.

5
Key Financial Indicators

• Measures of liquidity
• See equations 1 and 2 page 13 of booklet
• Measures of solvency
• See equations 3 6 page 14
• Measures of profitability
• See equations 7 8 page 15
• Measures of economic efficiency
• See equations 10 14 pages 16-17
• Measures of debt repayment capacity
• See equations 15 17 page 17

6
Measures of Liquidity

• 1. Current ratio
• Current assets divided by current liabilities.
• Demonstrates ability to cover scheduled current
  liabilities for the
• coming year out current assets and still have
  cash left over.
• Should exceed 1.0 to be technically liquid.
• Some firms fail despite exceeding this hurdle.

7
Measures of Liquidity

• 1. Current ratio
• Current assets divided by current liabilities.
• Demonstrates ability to cover scheduled current
  liabilities for the
• coming year out current assets and still have
  cash left over.
• Should exceed 1.0 to be technically liquid.
• Some firms fail despite exceeding this hurdle.
• 2. Working capital
• Current assets minus current liabilities.
• Expresses liquidity in dollars rather than
  ratio.
• Should be positive.
• Cash is King!

8
Liquidity Trends
Survived
Failed
Page 13
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
9
Liquidity Trends
Survived
Failed
Minimum
Page 13
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
10
Liquidity Trends
Desired level varies by type of firm
Survived
Failed
Page 14
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
11
Measures of Solvency

• 1. Debt ratio
• Total debt divided by total liabilities.
• Demonstrates ability to liquidate the firm,
  cover all liabilities out
• of all assets, and still have cash left
  over.
• Should not exceed 0.50 to minimize financial
  risk exposure.
• Some firms fail however at lower levels.

12
Measures of Solvency

• 1. Debt ratio
• Total debt divided by total liabilities.
• Demonstrates ability to liquidate the firm,
  cover all liabilities out
• of all assets, and still have cash left
  over.
• Should not exceed 0.50 to minimize financial
  risk exposure.
• Some firms fail however at lower levels.
• 2. Leverage ratio
• Total debt divided by equity or net worth.
• Often a credit standard in loan approval
  decisions.
• Should not exceed 1.0 to minimize financial
  risk exposure.
• Effects of rising interest rates.

13
Solvency Trends
Failed
Survived
Page 15
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
14
Solvency Trends
Failed
Maximum
Survived
Page 15
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
15
Measures of Profitability

• 1. Rate of return on assets
• Net farm income before interest divided by
  total assets.
• Demonstrates the return to management and total
  capital invested
• in the firm.
• Should be positive the higher the better.

16
Measures of Profitability

• 1. Rate of return on assets
• Net farm income before interest divided by
  total assets.
• Demonstrates the return to management and total
  capital invested
• in the firm.
• Should be positive the higher the better.
• 2. Rate of return on equity
• Net farm income divided by total equity.
• Demonstrates return to owners investment in
  the firm.
• Should be positive the higher the better.

17
Profitability Trends
Survived
Failed
Page 16
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
18
Profitability Trends
Survived
Minimum
Failed
Page 16
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
19
Measure of Debt Repayment Capacity

• 1. Term Debt and Capital Lease Coverage Ratio
• Net cash income divided by scheduled principal
  payments
• on term loans and capital leases
• After provision for taxes and withdrawals.
• Should be greater than 1.0.

20
Measure of Debt Repayment Capacity

• 1. Term Debt and Capital Lease Coverage Ratio
• Net cash income divided by scheduled principal
  payments
• on term loans and capital leases
• After provision for taxes and withdrawals.
• Should be greater than 1.0.
• 2. Debt burden ratio
• Total liabilities divided by net income
• After provision for taxes and depreciation
• Should be as low as possible to avoid financial
  risk exposure

21
Debt Repayment Capacity
Desired level varies by type of firm
Survived
Failed
Page 18
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
22
Some Conclusions.

• Indicators of growth/survival
• Increasing liquidity
• Increasing solvency
• Increasing debt repayment capacity
• Increasing profitability

• Indicators of potential failure
• Declining liquidity
• Declining solvency
• Decreasing debt repayment capacity
• Decreasing profitability

23
Tale of Two Cities
Failed
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
24
Tale of Two Cities
Failed
Failed
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
25
Tale of Two Cities
Failed
Failed
Failed
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
26
Tale of Two Cities
Failed
Failed
Failed
Failed
Source W. H. Beaver, Financial Ratios and
Predictors of Failure, Journal of Accounting
Research
27
Sample Question
Same firm level data used in Slide Show 1
Is this firm liquid, solvent, profitable and can
it cover its term debt and capital lease payments?
28
Sample Question
Step 1 Calculate the following 1. Current
assets and total assets 2. Current liabilities
and total liabilities 3. Net income 4. Equity (or
net worth) Total current assets 10,000
11,000 22,000 43,000 Total current
liabilities 1,200 7,500 7,213
15,913 Total assets total current assets
76,500 14,000 99,500 233,000 Total
liabilities total current liabilities 29,500
1,200 46,613 Equity 233,000 46,613
186,387 Cash receipts from product sales
73,000 Total operating expenses 51,200 2,500
7,400 61,100 Net income from operations
73,000 61,100 11,900 Net income before taxes
11,900 Net income 11,900 7,213 4,687
29
Sample Question
Step 2 Calculate the following 1. Current
ratio 2. Debt and leverage ratio Asset liquidity
analysis Total current assets 10,000 11,000
22,000 43,000 Total current liabilities
1,200 7,500 7,213 15,913 Current ratio
43,000/15,913 2.702 Working capital 43,000
15,913 27,087 Solvency analysis Total assets
total current assets 76,500 14,000 99,500
233,000 Total liabilities total current
liabilities 29,500 1,200 46,613 Equity
233,000 46,613 186,387 Debt ratio
46,613/233,000 0.20 Leverage ratio
46,613/186,387 0.25
30
Sample Question
Step 3 Calculate the following 3. ROA and
ROE Total assets 233,000 Equity 186,387
Cash receipts from product sales 73,000 Total
operating expenses 51,200 2,500 7,400
61,100 Net income from operations 73,000
61,100 11,900 Net income before taxes
11,900 Net income 11,900 7,213 4,687
Profitability analysis ROA (4,687
2,500)/233,000 0.0308 or 3.1 ROE
4,687/186,387 0.025 or 2.5
31
Sample Question
Step 4 Calculate the following 4. Term debt
and capital lease coverage ratio 5. Debt burden
ratio Debt repayment capacity analysis Net cash
income 4,687 7,400 12,087 Principal
payments 5,000 Coverage ratio 12,087/5,000
2.42 Debt burden analysis Net income
4,687 Total liabilities 46,613 Debt burden
ratio 46,613/4,687 9.95
32
Multiple Uses of Financial Indicators
33
Historical Analysis

• A look backwards like the Beaver study.
• Comparison of current performance with past
  performance.
• Recommend doing this at the enterprise level as
  well as for the farm as a whole.

Page 19
34
Historical Analysis

• A look backwards like the Beaver study.
• Comparison of current performance with past
  performance.
• Recommend doing this at the enterprise level as
  well as for the farm as a whole.
• Reasons underlying unwanted trends such as the
  declines in last two years?

Page 19
35
Comparative Analysis

• Compare the firms current performance with the
  performance of similar operations like the Beaver
  study did.
• Benchmark analysis at enterprise level should be
  done whenever possible.

Benchmark
Your firm
Page 20
36
Comparative Analysis

• Compare the firms current performance with the
  performance of similar operations like the Beaver
  study did.
• Benchmark analysis at enterprise level should be
  done whenever possible.
• Address reasons why your firm is performing more
  poorly than other comparable operations before it
  is too late.

Benchmark
Your firm
Page 20
37
Pro Forma Analysis

• Stress testing current expected cash flows by
  varying prices, unit costs and yields (Slide Show
  3).
• Look at implications of longer run price and unit
  cost trends on future financial health when
  making major decisions.

38
Forces of change.

• Impacts of rising unit costs of production
  inputs.
• Prices, costs and yields can all affect the
  financial health of the firm.
• Failure to account for the risk associated with
  adverse trends can lead to failure of the firm.

39
Sources of Uncertainty

• Global trends in production and consumption
• Energy prices and core inflation trends
• Interest rates and exchange rates
• WTO and the 2007 farm bill

40
Any Questions?