A number of ratios have been developed to assist in the review of the balance sheet. These ratios serve as useful tools for evaluating the financial health of an agricultural business enterprise. The following sections will discuss these ratios in detail. Four categories of ratios can be calculated from the balance sheet and income statement to aid in making financial decisions.
Categories of Financial Ratios in Agriculture
There are four categories of ratios that can be derived from the balance sheet and profit and loss statement. Three categories (Liquidity, Leverage, and Activity ratios) can be calculated from the balance sheet, while one category (Profitability ratios) is derived from the income statement. The categories of ratios are:
- Liquidity ratios
- Leverage ratios
- Activity ratios
- Profitability ratios
This article will focus on liquidity and leverage ratios in detail.
Read Also: Nine (9) Nutrient Requirements of Rabbits
1. Liquidity Ratios
Liquidity ratios measure the ability of an agricultural business to meet its short-term debt obligations. These ratios assess whether a business can pay off its short-term liabilities when they become due. Liquidity ratios also show how many times short-term debt obligations are covered by cash and liquid assets.
If the ratio is greater than 1, it indicates that short-term obligations are fully covered. Generally, the higher the liquidity ratios, the greater the margin of safety a business possesses to meet its current liabilities. Ratios greater than 1 indicate that the business is financially stable and less likely to encounter financial difficulties.
There are two main liquidity ratios that help assess whether a business has sufficient cash or equivalent current assets to pay its debts as they become due. In other words, these ratios focus on the solvency of the agricultural business. A business that cannot meet its debt obligations becomes insolvent.
Liquidity ratios focus on the short term and make use of the current assets and liabilities shown in the balance sheet. The two main liquidity ratios are:
i. Current Ratio: The current ratio estimates whether the business can pay debts due within one year from its current assets. A ratio of less than 1 is often a cause for concern, particularly if it persists over time.
The current ratio is approximately 5, which implies that the farm can meet its current obligations five times over. This result indicates that the farm is financially secure in the short term.
2. Quick Ratio: The quick ratio, also called the “acid test” ratio, is a more stringent measure than the current ratio because it excludes components of current assets that are not readily convertible into cash. Inventories, which are assumed to be the least liquid component of current assets, are subtracted from the calculation.
Inventories refer to stock of goods ready for sale, which are less liquid than other current assets. The quick ratio is 3.25, which is lower than the current ratio. This suggests that the farm can meet its debt obligations three times using its most liquid current assets.
This indicates that the quick ratio is a better measure than the current ratio, as it accounts for the difficulty of converting inventories into cash in times of financial strain.
2. Profitability Ratios
Profitability ratios are among the most frequently used tools in financial ratio analysis. These ratios help determine the farm enterprise’s overall efficiency and performance, focusing on the farm’s bottom line and return to investors. They are designed to measure a farm’s ability to generate profit. The key profitability ratios include:
i. Return on Farm Assets (ROA): Return on Farm Assets (ROA) represents the total income generated from the farm divided by the total assets employed to generate this income. ROA is adjusted by subtracting unpaid family labor as a non-cash expense, which allows for better comparisons between farms that pay family wages and those that do not.
It is important to distinguish whether assets are valued at cost or market prices, as this can affect the ROA’s accuracy. A key strength of ROA is that it accounts for all financing sources, as interest payments are included in income.
ii. Return on Farm Equity (ROE): Return on Farm Equity (ROE) measures the income generated from the owner’s equity in the farm business. Similar to ROA, the value of assets plays a significant role in determining ROE. A higher return on equity relative to return on assets over the long run indicates effective use of debt leverage. However, this relationship comes with a trade-off between higher returns and increased risk.
iii. Operating Profit Margin Ratio: This ratio evaluates the proportion of each unit of revenue that flows into profits. It must be interpreted in conjunction with the asset turnover ratio, as a lower profit margin can be compensated for by higher asset turnover. Operations with higher capital investment typically exhibit higher profit margins paired with lower asset turnover.
Read Also: Principles of Feeding Rabbit and Feed Resources
3. Activity Ratios
Activity ratios, also known as operating or management ratios, measure how efficiently a farm uses its assets, such as inventories, accounts receivable, and fixed assets. Common activity ratios include:
i. Average Collection Period: This ratio applies to credit sales and indicates how long it takes for a farm to collect sales revenue from customers. A longer collection period may lead to difficulties in meeting financial obligations. A rise in the average collection period (ACP) is a signal to tighten credit sales.
ii. Inventory Turnover:
Inventory turnover measures how frequently inventory is turned over in a year. A higher ratio is preferable as it implies greater efficiency. However, management should avoid excessive inventory to prevent missing sales opportunities.
iii. Fixed Assets Turnover: Fixed assets turnover evaluates how efficiently a farm’s fixed assets (e.g., land, buildings, equipment) are used to generate sales. A low ratio may indicate excessive investment in fixed assets relative to sales.
iv. Total Assets Turnover:
Total assets turnover considers both fixed and current assets and provides insight into the overall efficiency of asset use. A low ratio suggests an excessive amount of assets being used to generate sales and signals a need to liquidate or reduce underutilized assets.
In this article, the various categories of farm financial ratios, their importance, and the thresholds that ensure the solvency, liquidity, and profitability of agribusiness enterprises have been explored.
There are three main categories of farm ratios: liquidity ratios, solvency ratios, and profitability ratios. Liquidity and solvency ratios are derived from the balance sheet, while profitability ratios are calculated from the income or profit and loss statement. These ratios are critical in assessing the financial status and viability of a farm business enterprise.
Read Also: The Easiest Way to Fix Garbage Disposal Jam
