As I grow older – I am in my early 60s – I am even more aware of the importance of staying healthy. One of the best books I read on this issue is Younger Next Year by Chris Crowly and Henry Lodge. In this book, it refers to three key pillars to maintaining and even improving one’s state of health. They are stability, cardio and strength; each has a vital role in enhancing your health. We spend a lot of time talking about properly saving and investing money to ensure a happy retirement, but if you are not investing in your own health, what good is monetary wealth?
As an accountant and financial adviser in the agriculture field, I have come to realize these same health principles apply to ensure the viability and growth of your dairy operations. One of the best ways to assess your farm’s health is by using the same three key ratios your financial institution employs to evaluate your dairy operations:
- Working capital ratio (Flexibility)
- Debt-to-equity ratio (Strength)
- Debt service ratio (Cardio)
Now, let’s look at how each of these ratios impacts your farm’s financial health:
- The working capital ratio is calculated by dividing current assets by current liabilities, both of which are taken from your balance sheet. A strong ratio provides you the flexibility to make good marketing decisions since you don’t have to prematurely liquidate inventory to meet current financial obligations. You also have more versatility to purchase capital assets since external funding may not be required or at least is reduced. There is an urgency to this because a poor ratio may mean you don’t have enough current funds to meet the obligations of the next production cycle.
- The debt-to-equity ratio is a longer-term ratio focused on assessing the strength of your farm to weather adversity and capitalize on opportunities. This ratio is calculated by dividing your external debt by your equity, which includes accumulated profits left in the company and any personal contributions made to the farm (e.g., shareholder loans). An improvement in this ratio over time ensures the viability of your farm and positions you well for unseen challenges.
- The final ratio, the debt service ratio, is probably the most important ratio since it determines whether your farm is profitable enough to service its existing debt obligations. This ratio is calculated by dividing earnings before interest, taxes and capital asset amortization by your annual debt obligations, which usually include principal payments and interest. I consider this the “cardio” of your farm, since the ongoing profitability of your farm is like the need for blood to be continually flowing through your body. I can survive with limited strength and flexibility, but I cannot survive without a sustained heartbeat. A farm that fails to generate ongoing profits will meet a similar fate.
When it comes to using these key ratios to evaluate the health of your farm, certain conditions need to exist.
Firstly, the financial statements that you use to calculate your health must be prepared on the accrual basis versus the cash basis. Accrual basis financial statements provide the complete picture of all your assets and liabilities at a point in time, which includes inventory, prepaids, receivables, debt obligations and input payables.
Your statement of operations on an accrual basis also properly matches your effort (i.e., all your expenses) with your results, which includes your revenue regardless of whether you have converted your effort into cash and deposited it in the bank.
Secondly, your financial information needs to be accurate. Any decisions you make should be based on sound financial reporting.
Lastly, your financial information needs to be produced on a timely basis so you can quickly assess past decisions and have the necessary data to make informed decisions impacting your future.
Tracking your progress
Each one of these ratios will have a certain threshold your financial institution wants to see you exceed to ensure you are heading in the right direction. For example, a ratio between 1 and 1.25 is not uncommon for a debt service ratio. Ongoing communication with your lender is important so you know how they are calculating the ratios, along with their specific threshold tolerances. Communication is especially important if you anticipate upcoming challenges. You and your lender can discuss options to navigate troubled times.
Improving your financial fitness
With each ratio, there are certain actions you can take to improve your situation. For example, you can improve your working capital ratio by selling redundant assets and increasing your bank balance. For the debt service ratio, you can extend your repayment terms to lessen your annual principal payments.
However, the one underlying strategy to improve all ratios is a concerted effort to improve your profitability. Sustained profitability creates ongoing positive cashflow to help you grow your operation and provides a strong track record for your lenders to loan upon.
One of the most efficient ways to improve profitability is to follow the principle of starting at the top. This involves reviewing your most important balances from your statement of operations and looking for small improvements to improve profitability. For example, what small changes could you make to increase revenue? Once you’ve considered this, challenge your key input costs like feed and animal purchases to make modest improvements. You can then work your way down the statement of operations for other small improvements, including repairs and maintenance and labour costs.
The reason we want you to start at the top is it helps you focus on those areas with the greatest impact. A 5% improvement in your revenue can have an impact on your profitability that is three times greater than a similar improvement in your repairs and maintenance expenses. I have seen instances where a small improvement to the most important revenue and expense categories has doubled bottom-line profit.
The viability and prosperity of your dairy operation are contingent upon creating an operation that is healthy and receptive to change. Make it a habit to continually look for ways to improve the health of your most important asset and create a legacy to be proud of.
