Farm Viability
Frank Wiebe, CA, Partner
Wheat, Oats and Barley
November, 2007
A farmer is always thinking about the viability of his or her farm. Viability is normally understood to be the ability to survive and prosper over a long period of time. There are many financial ratios that may be used to measure the viability of the farm, however we will look at three main factors: liquidity, solvency, and profitability. Various ratios are used in assessing each factor and they should be used interdependently and not in isolation of each other. Monitoring the change of these ratios on a periodic basis for your farm and comparing to benchmarks for the sector of agriculture you are in, will be very important.
Liquidity
Liquidity is the ability of the farm to meet its financial commitments as they become due in the ordinary course of business. Three key ratios that determine liquidity are working capital, current ratio, and debt structure ratio.
Working capital is calculated as current assets minus current liabilities. This ratio indicates the amount of capital that is available for current operations. Normally, the goal is to have the ability to pay at a minimum three months of expenses from the working capital.
Current ratio is calculated as current assets divided by current liabilities. This ratio reflects the ability to pay expenses, as they occur, with current assets. A ratio of greater than one is preferable, but aim for greater than two. If the ratio is very high, say greater than four, you may not being using your resources efficiently.
Finally, debt structure ratio is calculated by determining the percentage of current liabilities of the total liabilities. This compares the short term debt to the total amount of debt to be repaid. Aim for a percentage of debt of less than 20 per cent; a high ratio is indicative of a high demand of cash in the current year.
Solvency
Solvency is the ability of a farm to pay all its liabilities through its assets. Four key ratios which are indicators of solvency are debt to equity ratio, debt to asset ratio, equity ratio, and debt servicing ratio.
Debt to equity is calculated by dividing total liabilities by total equity. This ratio indicates how the farm is financed. Be aware that this is normally calculated using the fair market value of the assets versus the accounting cost as reflected in the financial statements. Lower ratios are preferred by the banks so aiming for a ratio of four is a good practice. A higher ratio indicates that there is greater long term risk and less flexibility.
The debt to asset ratio is calculated by dividing total liabilities by total assets. This ratio indicates how much the operation is leveraged. Again, the asset values used are fair market value and a ratio of five or less is preferable; generally, the higher the ratio, the higher the risk of insolvency.
Equity Ratio is determined by dividing total equity by total assets. This reflects the amount of the assets that are financed by the farmer. Once again, the value of the assets is determined using fair market value a ratio of five is optimal. The solvency of the farm increases as the ratio increases.
Lastly, the debt servicing ratio is calculated by dividing the debt servicing capacity by the total interest and principal paid on all term debts. This ratio indicates the ability of the farm to generate cash to repay its term debt. The debt servicing capacity is calculated by determining the net income before interest on term debt, income taxes, amortization and farmer’s wages or withdrawals. Aim for ratios higher than two; the higher the ratio, the greater the confidence by the financial institution that you will be able to service the term debt.
Profitability is always important. But, a healthy farm will be profitable, ensuring that enough resources will be generated to meet the commitments for the payment of the expenses and the debt which it has incurred. The benchmarks mentioned are general benchmarks and each farm should ensure they compare their specific ratios to the benchmarks that are available for the sector of agriculture that they are involved in.
For more information, call your local BDO office or contact our National office at:
Telephone: 1-800-805-9544 Fax: (416) 367-3912 e-mail: info@bdo.ca
This bulletin is a publication of BDO Dunwoody LLP on developments in the area of taxation. This material is general in nature and should not be relied upon to replace the requirement for specific professional advice. The information in this bulletin is current as of December 31, 2005.
© 2005 BDO Dunwoody LLP
