When was the last time you assessed your financial health? Unless you ask the right questions and track results, you are merely guessing at how your business performs. In today’s volatile marketplace, you have to do better. Use these tips to help determine the financial health of your dairy business.
Determine your equity stake
Get out your latest balance sheet and determine your equity stake in the business. (Total assets – total liabilities = % equity.) Percent owner equity measures your financial position and well-being at a given time.
If your equity ratio is 50 percent, that means you own 50 percent of the business and your lenders own the other half. The median equity position for dairy producers enrolled in the Illinois Farm Business Farm Management Association for 2003 through 2006 was 69.7 percent. The top 25 percent of these producers owned 84.8 percent of their business.
Your equity stake can increase in two ways — growth through profits and growth through appreciation of assets.
Probably the most important factor to look at on your balance sheet is earned net worth. (Earned net worth is owner equity calculated on a cost basis.) Specifically, you want to know if it is growing, shrinking or holding steady.
To determine this, you will need to use a two-column balance sheet created by the Farm Financial Standards Task Force and used by most financial institutions. This balance sheet has one column for fair market values and a second column for cost-basis value. Earned net worth is reflected on the cost side.
When earned net worth remains the same or erodes, and the fair market value equity continues to increase, it is a big red flag. It tells us that inflation is the only thing increasing your financial position. We have seen galloping increases in fair market value net worth during the past few years due to inflation of land prices and the increase in fair market value of livestock. Your lender is interested in the fair market value of your assets since he would use those to liquidate your loan if necessary, so the values do need to reflect current economic conditions. However, the bottom line is that earning equity the old-fashioned way — through profits — is the only true way to succeed in the long run. Therefore, you want earned net worth to increase over time.
Cash-strapped vs. liquidity
When you focus too much on growth and investment in land, equipment or breeding stock, you can become starved for cash liquidity. Remember, the producer who has liquidity in cash has more options and more flexibility than the individual whose equity is locked up in producing assets.
One measure of liquidity is your current ratio. The current ratio is a comparison of current assets to current liabilities. Current assets are assets that will normally be liquidated in the next 12 months. Current liabilities are obligations, such as your operating note and the principal due on term notes within the next 12 months.
Generally, lenders like to see a current ratio of 2: 1, which means that you have $2 of current assets for each $1 of current liabilities. The 2:1 ratio indicates that you will have little problem meeting your debt-service needs in the coming year. Dairy producers can operate with a little lower current ratio than other agricultural producers because you receive regular monthly milk checks. Dairy producers enrolled in the Illinois Farm Business Farm Management Association reported a median current ratio of 1.55:1 for the period of 2003 through 2006. The top 25 percent of Illinois dairy producers reported a current ratio of 3.08:1!
When you look at the financial standards listed here, don’t get hung up on the fact that the examples used are from Illinois producers. Whether your business resides in California, Wisconsin, or Illinois, it doesn’t really matter. Just remember that your best comparison comes from results reported by fellow dairy producers.
Take some time to assess if your business is making progress. Then, apply these measures and develop a plan to improve your financial position going forward.
Darrell L. Dunteman is an agricultural financial consultant and accountant in Bushnell, Ill. He also edits the Farm and Ranch Tax Letter, a monthly agricultural tax newsletter. E-mail your questions to Dunteman at: email@example.com