Look at multiple benchmarks to know financial status

Last month, we took a look at the dairy enterprise data for 18 Ohio dairy farms that participated in the Ohio Farm Business Analysis Program. While there was a range in performance, which is normal, the average net return per cow of $759 was well above the four-year average of $320 per cow (2017-2020). 

Net returns were heavily supported by participation in the Coronavirus Food Assistance Programs, and on a lesser level by indemnities from the Dairy Margin Coverage Program. This week we will look at a few of the financial indicators for these farms, focusing on liquidity and solvency measures. 

Liquidity

Liquidity is cash flows in and cash flows out of a dairy farm. Farms with strong liquidity measures have plenty of cash available to pay current obligations and purchase inputs when they are needed. They also have cash available to purchase inputs ahead when good deals are available. 

Liquidity is measured using the balance sheet, specifically current assets and current liabilities. Current assets include cash and near-cash items such as grain and feed inventories, accounts receivable, prepaids, supplies on hand and market livestock. These are items that if sold today, in a reasonable marketplace, should return their market value. 

The current ratio compares the total current liabilities to the total current assets. I like to think of it this way: all farms started the year with a current ratio of 1.48. That means they had $1.48 of current assets for every $1 of current liabilities. The good news is that the average current ratio was 2.14 at the end of the year or $2.14 of current assets for every $1 of current liabilities. 

For agriculture, we would like to see a current ratio over 2, so that improvement of 0.66 during 2020 indicates that cash flow concerns eased throughout the year. 

That said, it is always important to think through how and why a farm’s current ratio improved. Was it because there is more cash, larger (quantity) feed inventories, more prepaids? Those indicate an improvement in position that the farm will really feel. 

If cash, inventories and prepaids are about the same at the end of the year, but the higher total current asset value is due to the feeds being valued higher than at the beginning, the farm won’t feel as much or any positive impact. 

Notice that in the table, there may be two benchmark figures. The first, more than 2 for the current ratio, is an ag industry standard. The second, more than 3 for the current ratio, is the 15 Measures of Dairy Farm Competitiveness competitive level developed specifically for dairy farms. With the increased volatility in milk prices, the higher level helps insulate a dairy farm from cash flow challenges. 

Working capital

The difference between current assets and current liabilities is the farm’s working capital. For all farms and the high 25%, working capital increased from the beginning to the end of the year. 

Working capital is a number. On its own, it does not tell us if it is sufficient for the size of the business. When we compare it to the gross returns of the business, we have a better feel for sufficiency. 

Solvency

If you are painting and need to get oil-based paint out of your paintbrush, you get out a solvent, turpentine, to make it go away. When we talk about financial solvency and the debt to asset ratio, we are talking about what would be left if the business went away. 

The debt to asset ratio compares the total debt from the farm’s balance sheet to the total assets. All farms averaged 35% at the beginning of the year, and 33% at the end. 

On average, at the end of the year, 33% of the assets were owned by someone else. If the business was dissolved, the owner would still have approximately 67% of the value of the farm’s assets left for themselves (recognizing that the assets may or may not achieve their stated market valuations in a sale, and there would be costs of sale and potential contingent tax liabilities). 

The high 25% farms were more highly leveraged but were able to decrease their debt to asset ratio from 45% to 41% over the year. Over time, with continued profitability, those farms should be continuing to push that ratio down to less than or equal to 30%. 

Whole picture

Meeting one or two financial indicators does not indicate overall financial well-being of a farm business. It is important to look at the whole range of indicators or benchmarks as well as monitor overall and enterprise profitability. What is certain is the need to know your numbers and use them to make informed decisions. 

We are two months away from 2022, and the next opportunity to start putting numbers together for your dairy farm. Contact me at shoemaker.3@osu.edu to set your farm up for your 2021 analysis.