Financial Analysis of an Agricultural Business - the Balance Sheet
Farm Business Management Update, August/September 2006
By Alex White (email@example.com), Instructor, Agricultural Finance and Small Business, Department of Agricultural and Applied Economics, Virginia Tech.
The previous article briefly discussed some of the main tools of financial analysis, such as breakevens, financial ratios, and marginal analysis. These powerful tools identify the strengths and weaknesses of a business. However, you will need good, dependable records to actually perform these analyses. This article will briefly introduce the one of the main financial statements that I like to use when analyzing a business – the Balance Sheet.
The balance sheet, also called the financial statement, lists all of the assets and liabilities of the business as of a certain date. You will get a mixed bag of balance sheets when working with producers – some will include only business-related assets and liabilities, while others may include personal assets and liabilities. I tend to use the combined business and personal balance sheet whenever possible. My reason is that most businesses are sole proprietorships, so the personal assets are indistinguishable from the business assets in the eyes of the courts. Also, I can always omit the personal assets from my analysis, and I’d rather have more information than less!
The assets are usually grouped in the following categories:
Recently, I’ve been seeing more balance sheets that just list Current and Non-Current Assets. These balance sheets combine intermediate and long-term assets. From an analysis standpoint this alternative doesn’t present much of a problem – none of the ratios I use are affected by the use of non-current assets instead of intermediate and long-term assets.
One of the big problems with balance sheets is valuation of the assets, that is how do you determine the value for each asset? You can use two methods: book value or market value. Book value is how the business world values assets. With this method, assets are listed at their original purchase value. All accumulated depreciation is subtracted from the original cost to get the book value. With the rapid appreciation of real estate in Virginia, this method can understate the actual value of the assets by a tremendous amount.
The market value approach is more common. This method lists the assets at their estimated net market value. Net market value is the current value of the asset (in today’s market) minus the costs of disposing of the asset (transportation costs, commissions, etc.). The problem is accurately determining the current market value of the asset. To implement this method, you need to have a good feel for market values in your area. Watch out for artificially high values! If dairy cows are selling for $2,000 in your area, don’t use a value of $5,000 per cow. When in doubt, be conservative – you are better off undervaluing assets rather than overstating their value.
Liabilities are obligations that the business owes to its suppliers and creditors. It is usually relatively easy to identify the accounts payable and the periodic loan payments. However, short of contacting the individual creditors, it can be tough to determine the outstanding balances for loans. Liabilities are also grouped into three categories:
As with assets, you might see a balance sheet that combines Intermediate and Long-Term Liabilities into a “Non-Current Liabilities” section. Quite often you will have to work backwards to determine the principal due within one year and the principal remaining. Producers typically know how much they borrowed initially and the interest rates (APR) on the loans. They can also tell you the exact amount of the monthly payment. But they will just be guessing at the principal due this year and the principal remaining. You will have to estimate an amortization schedule to determine these figures or ask your lender.
The reason a balance sheet is called a balance sheet is relatively simple – the total assets must be balanced out by the total liabilities and the net worth (also called “owners equity”). I explain this to my students in terms of buying a car. If the purchase price of the car is $20,000, I can list the car as an intermediate asset worth approximately $20,000. I have two ways of paying for that car – using my own funds (equity) or using borrowed funds (liabilities). If I make a down payment, which would come from the net worth section, of $5,000 and borrow the remaining $15,000, my partial balance sheet on that day will look like this:
|Toaal Liabilities & Net Worth||$20,000|
So the balance sheet actually tells me what the business owns and how it has paid for those assets (liabilities or equity). As a rule, Net Worth = Total Assets – Total Liabilities is what makes a balance sheet balance.
A balance sheet is useful in analyzing the liquidity and solvency of a business. Liquidity is a measure of the business’ ability to meet its short-term obligations without disrupting the normal operations of the business. Solvency is a measure of the business’ overall capital structure – its total assets and total liabilities.
Liquidity is a crucial aspect of financial analysis. If a business is not liquid it may have significant problems meeting its cash flow requirements. Regardless of how good a producer is or how profitable a business is, if bills aren’t paid on time, the business will cease to be. If you have to resort to selling your breeding livestock or selling a parcel of land to meet your payments, you are disrupting the normal operations of the business. The main measure of liquidity is the Current Ratio (Current Assets/Current Liabilities). I like to see a current ratio of at least 1:1, preferably 1.5:1. The higher the better (to a point). A ratio greater than 1:1 indicates that the business has more than enough liquid assets (cash, checking, savings, etc.) on hand to meet any debt payments it owes this year. For example, a Current Ratio of 1.5:1 indicates that the business has $1.50 in liquid assets for every $1.00 it owes in debt payments (including accounts payable and credit cards) this year.
Solvency is also a critical factor in financial analysis. If a business has too many liabilities in comparison to its assets, tough times are ahead and large debt service payments will put a lot of pressure on the cash flow of the business. The main measure of solvency is the Debt/Asset Ratio (Total Liabilities/Total Assets). Other measures you might run across include the Percent Equity (Total Net Worth/Total Assets) or the Debt/Worth (also called the “Leverage Ratio” and calculated as Total Liabilities/Total Net Worth). I like to see a Debt/Asset ratio of less than 50%. For this ratio, the lower the better (from a risk standpoint). I’m currently working with a producer who has a Debt/Asset ratio of 65%. He has borrowed $0.65 for every $1.00 of assets in his business. As you would expect, a fairly substantial portion of his income is automatically diverted to his loan payments – leaving him with severe cash flow problems.
From a lender’s standpoint, you can also use a balance sheet to determine who all of the business’ creditors are and what assets are available as collateral. At a glance, you can see how the debts are structured – were the intermediate assets funded with loans with a life of 1-10 years or were real estate assets funded with longer-term loans? Too often, I see the repayment schedules of agricultural loans structured over a very short time period. Again, this improper debt structure leads to cash flow problems for the business. And yes, “cash is king” in the business world.
Future articles will focus on income statements, cash flow statements, and the main financial ratios. I’ll also discuss the financial analysis process that I use to give you some tips to help you when a producer drops a stack of financial records on your desk and says “help!”
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