When planning a dairy modernization, the first questions that come to mind are probably of the building and construction variety. However, before the builders can break ground, the bank financing the operation has to approve the plan. For most major renovations or expansions, a lender will want a business plan to outline how the farm made these modernization plans and the goals for the farm's future success. For that plan to be approved, a comprehensive financial plan must be included that proves the farm's past profitability and justifies the expansion for further profits down the road.
Here we outline five key financial ratios any farm should consider when creating a plan:
The current ratio is taken from the balance sheet - a summary of the farm's assets and liabilities. It measures liquidity, or whether the current assets could pay off all current liabilities. Current assets are anything that would be used or sold within a year and includes all cash or checking balance, the value of crops and feed, and the most recent milk check. On the liability side, this includes any accounts payable over 30 days, including credit cards or lines of credit. The current ratio gives the lender an idea of whether the bills get paid on a regular basis and if the farm will be able to make its loan payments on time.
A ratio of 1.75 would mean that a farm has $1.75 to cover every $1.00 of current debt. Banks would like to see a ratio over 1.7 to indicate a strong financial position. A higher ratio is desirable since it provides more resilience during financial downturns.
Debt to Asset Ratio
While the current ratio compares those aspects of the balance sheet that change over the course of a year, the debt-to-asset ratio compares total farm debt to total farm assets. In effect, it represents the bank's share of the business. The higher this ratio, the more risk the farm has and a high ratio may limit the ability to borrow additional money. This measure is included in the "solvency" bracket of financial ratios, and can be imagined as how well the business is able to remain "afloat."
A ratio of 28% indicates that for every $1.00 of assets a farm has it can cover $0.28 of debt. Another way to look at it is the bank owns 28% of the business. In this case, a lower ratio or percentage is positive. Banks prefer a debt-to-asset ratio below 60 percent for farms considering expansion. Well-established dairies may have debt-to-asset ratios below the 30 percent "comfort" benchmark.
Term Debt Coverage
Term-debt coverage measures the repayment capacity of a farm. This measure compares the ability of a farm to pay all intermediate (between 1 and 10 years) and long-term (greater than 10 years) loans. If the term-debt coverage ratio is less than one, then the farm has to liquidate assets--sell inventories, increase accounts payables, or borrow on the line of credit to cover loan payments.
In order to stay out of the danger zone (a red area) term-debt coverage should be greater than 1.2, but needs to reach levels of 1.5 or more to be in the green zone. The higher the ratio is, the more positive the outlook. Many lenders require a term debt coverage of at least 1.25 to consider a plan viable. A ratio at this level provides some "cushion" to withstand business downturns and still keep loans paid on time.
Net Farm Income
While no one number can capture the desired "net farm income," this measure is generally considered one of the most important financial measures for a business. It measures profitability or at its most basic level: the value of goods produced (milk, replacements) compared to the cost to produce those goods.
Lenders look for this number to show steady growth over time, as reflected by increasing net worth. Net farm income represents the returns to the farm owner's labor, management, and equity in the business. Historical goals for Net Farm Income would be $800 to $1,000 per cow per year.
Rate of Return on Farm Assets
Also categorized under farm profitability, rate of return on farm assets measures the average interest rate that all the investment on the farm earns (both from the bank's and the farm owner's standpoints). When looking at farm assets, one of the major items that leaps off the page is land. Farmland does not depreciate, and land values can increase especially over the many years that the farm has been in operation. This can hurt the rate of return on farm assets as it pushes the asset side of the equation out of proportion to the income and interest earned on the farm. However, banks that are experienced in agricultural lending are aware of this, and look for the same sign of profitability that they do with net farm income: gradual increases over time.
On the financial scorecard rubric, a rate of return on farm assets greater than 8% is considered most positive. The larger the ratio, the better. For the last 50 years, agricultural businesses have averaged a 3 to 5% Rate of Return on Assets, so the financial scorecard goals reflect above average performance.
When a lender looks at these ratios, it is important to remember that in a modernization a farm will not be perfect in every area. A business plan that can show how the farm improves on these ratios over time will show the business's ability to grow and be successful. Farms and lenders should consider the overall goals of the business, and how the improvements will help position the farm for long-term success.