Banking on Financial Ratios
By Michael Machon, CA, CFP, Partner
BDO Dunwoody
The relationship that a farm business has with its corporate banker is becoming ever more important in managing an agricultural business today in Canada.
Have you ever considered what is required to finance the proposed expansion of your enterprise? Or perhaps whether the financial strength of your farm business warrants lower borrowing costs? How will the corporate banker respond to this year’s financial results?
Reviewing your financial ratios can answer these types of questions and your banker will be interested in the following ratios:
- Leverage – How does the debt compare to equity? What is the financial leverage?
- Liquidity – Can a business meet its short term obligations?
- Debt Coverage – Can the cash flow of a business meet its future debt obligations?
Leverage – Before borrowing more debt to finance a significant expansion, management should assess whether the enterprise can accept this additional financial risk. The Debt to Equity ratio is measured as follows: Debt (total liabilities, excluding shareholder loans) divided by Equity (total equity including loans owing to shareholders). A Debt/Equity ratio of 1.5 would mean that there is 1 dollar of equity for every 1.5 dollars of debt.
Possible benchmarks would be:
- Debt/Equity ratio under 1.0 - GREEN - Generally good, debt should be manageable. A strong ratio may also indicate that financing rates can be reduced and future investments may not significantly increase financial risk,
- Debt/Equity ratio between 1.0 and 2.0 - YELLOW - Proceed with caution, debt may be manageable, however, planned investments should be reviewed.
- Debt/Equity ratio over 2.0 - RED - Enterprise may be over-leveraged, and a higher level of caution is needed. Expansion plans should be viewed with caution; lenders may be requesting higher interest rates.
Liquidity – The Current Ratio assists in assessing whether sufficient working capital exists to meet short term obligations. The Current Ratio is determined as follows: Current Assets / Current Liabilities. Current Assets would include cash, accounts receivable, inventory etc. and Current Liabilities would include demand operating bank loans, accounts payable and current portion of long term debt. A current ratio of 2.0 would mean that there are 2 dollars of current assets available for every dollar of current liabilities. If term debt has a “due on demand” feature, then the entire debt may be treated as current, which could weaken the company’s Current Ratio and potentially result in a banking agreement covenant violation. Examine carefully the proposed terms of any new debt before accepting the credit terms. Also important is to consider using long term debt to finance long term assets, such as equipment or real estate, as opposed to borrowing on the operating line which puts undue pressure on the Current Ratio.
Possible benchmarks would be:
- Current ratio over 1.5 - GREEN – sufficient working capital appears to exist.
- Current ratio of 1.0 to 1.5 - YELLOW – working capital appears ok, however, more careful cash flow management may be necessary to ensure credit obligations are met.
- Current ratio under 1.0 - RED – working capital is deficient and has the potential to result in insufficient cash flow to meet day to day obligations. A review of the capital structure may be advisable and a possible restructuring of debt may also be advisable.
Debt Coverage – The debt coverage ratio assists in determining whether the enterprise is expected to have the cash flow available to meet its long term debt commitments. Simply put, how much coverage is available to meet debt payments? The debt coverage ratio is determined as follows: [Net Income + Amortization + Interest on long term debt] Divided By [Annual Principal Payments + Interest on long term debt]. A ratio of 2.0 would mean that there are 2 dollars of cash flow available for every dollar of debt commitments and would indicate coverage of 2 times.
Possible benchmarks would be:
- Debt Coverage over 1.5 times - GREEN – cash flow appears safe and continued profitability should ensure that debt obligations will be met.
- Debt Coverage of 1 to 1.5 times - YELLOW – careful management of its cash flow may be needed and taking on additional debt obligations should be reviewed cautiously before commitments are made.
- Debt Coverage under 1 times - RED – meeting future debt obligations may be at risk and it may be advisable to review the enterprises’ expected future cash flow.
Remember that your banker will be interested in these ratios, either as part of the annual credit review process or consideration of future credit availability. A strengthening or deterioration in these ratios in the current year will provide some insight as to how your bank will respond to the latest financial statement. In a deteriorating financial situation, it is critical that management recognize the financial ratio indicators and approach the bank with a practical plan to reverse the trend and how it will put the enterprise back on the road to improved ratios.
This material is general in nature and should not be relied upon to replace the requirement for specific professional advice.
BDO Dunwoody LLP is proud of its long association with British Columbia farmers. If you have any questions about your cash flow situation or any items discussed in this article, contact a BDO advisor at agriculture@bdo.ca.
This material is general in nature and should not be relied upon to replace the requirement for specific professional advice.
