Understanding the farm’s financial health - Part three

Part 3: Basic components to a successful business.

Getting your hands dirty with a soil test or with a farm financial test, both yield valuable findings.

In our last part of the series, we focused on the value of understanding the farm’s financial health and began with our “financial” soil sample of the farm. Our core samples so far have been the balance sheet and the income statement.

The final core sample for our test is the cash flow statement. This is actually a combination of the balance sheet and income statement. It takes information from both and explains what the sources of income were and how they were used by the farm. It focuses on repayment capacity or the ability to repay scheduled term debt and the farm’s ability to take on additional term debt. It also shows the farm’s ability to repay term debts on time.

Repayment capacity is not considered a measurement of the business’ performance. Instead, it looks at what dollars remain after paying for operating, investing, and financing activities.  The remaining dollars can then be used for future years. To evaluate these things, it focuses on the capital debt repayment capacity, capital debt repayment margin, replacement margin, term-debt coverage, and replacement margin coverage ratios. 

This is the point where everything we’ve been studying in our “financial” soil test starts to come together. We know what resources are available to be used.  We also know how we’ve invested those resources over time.  Most importantly, we now know what we have left over for next year. With this information we can start to answer some important questions about the farm business.

What is the farm’s operating capacity or size compared to its desired goals? Is it operating at, above, or below its ability to successfully reach them? What is the farm’s ability to meet goals and repay term debt? What changes should be considered?

These financial documents are critical pieces to understanding your farm’s financial health. Individually, they tell you about specific strengths and weaknesses that may be holding back your farm’s success.  They can even reveal opportunities for business growth. Most importantly, you can begin to understand your farm’s financial efficiency.

Financial efficiency shows the effectiveness of your management decisions. The decisions you’ve made in the past often impact the potential for future successes.  Especially if the same decisions are made over and over again. To find how efficient your farm is, begin by evaluating the farm’s asset-turnover rate.  This focuses on how well the farm uses its assets to generate income. Then evaluate where gross farm income is being spent by looking at the operating expense ratio, depreciation expense ratio, interest expense ratio, and net farm income ratio. With all four adding up to 100%, these help the farm manager to know how effectively income is being used across the farm.  

Compare this to our soil test example once more. When we start to think about how effectively our past practices have been, have we utilized our resources the best way possible to reach our goals? Are we getting the most out of what we’re putting in to the operation? Are there any limiting factors that we still need to address? What changes can we make now or work towards that would allow us to better improve our profitability and farm growth?

Think about these concepts on your own farm.  How does your farm’s repayment capacity affect the liquidity or ability to pay bills?  How does it affect the solvency or available assets you have to use to reach farm goals?  How does the farm’s profitability play into the repayment of debt?  Most importantly, how are your management decisions impacting the answers to all of these other questions?

In the next part of this Michigan State University Extension series, we’ll talk about when and how often you should be collecting these “core samples” and how staying well informed about your farm’s financial health will benefit your operation in the long-run.

This is the third of four short articles about farm financial health. Read the other parts by clicking on the links below:

Basic components to a successful business part one.

Basic components to a successful business part two

Basic components to a successful business part four

Did you find this article useful?