Class Pages  >  Section 3  >  Pages 1 - 4  >  Formulas Continued - page 303

## FORMULAS CONTINUED

### CAPITAL REPLACEMENT AND TERM DEBT REPAYMENT MARGIN

• Computation:
• Net farm income from operations
• + Total non-farm income
• + Depreciation/amortization expense
• - Total income tax expense
• - Withdrawals for family living
• = Capital replacement and term debt repayment capacity
• - Payment on unpaid operating debt from a prior period
• - Principal payments on current portions of term debt
• - Principal payments on current portions of capital leases
• - Total annual payments on personal liabilities (if not included in withdrawals)
• = Capital replacement and term debt repayment margin
• Interpretation: This measure enables borrowers and lenders to evaluate the ability of the farm proprietor to generate funds necessary to repay debts with maturity dates longer than one year and to replace capital assets. It also enables users to evaluate the ability to acquire capital or service additional debt and to evaluate the risk margin for capital replacement and debt service. This measure assumes that credit obtained for current-year operating expenses will be repaid in one year as a result of the normal conversion of farm production to cash. Unpaid operating debt from a prior period should exclude lines of credit and debt for livestock purchased in that period for sale in the current period (if part of the normal course of business).

### ASSET TURNOVER RATIO

• Computation: Gross revenues / Average total farm assets
• Interpretation: The asset turnover ratio is a measure of how efficiently farm assets are being used to generate revenue. A farm business has two ways to increase profits –- either by increasing the profit per unit produced or by increasing the volume of production (if the business is profitable). A relationship exists between the rate of return on farm assets, the asset turnover ratio, and the operating profit margin ratio. If the asset turnover ratio is multiplied by the operating profit margin ratio, the result is the rate of return on farm assets. Consequently, the same asset valuation approach should be used to calculate the asset turnover ratio as is used to calculate the rate of return on farm assets. The higher the ratio, the more efficiently assets are being used to generate revenue.

### OPERATION RATIOS

• Interpretation: Four ratios reflect the relationship of expense and income categories to gross revenues. The sum of the first three express total farm expenses per dollar of gross revenue.

### OPERATING EXPENSE RATIO

• Computation: (Total operating expenses – Depreciation or amortization expense) / Gross revenues

### DEPRECIATION EXPENSE RATIO

• Computation: Depreciation or amortization expense / Gross Revenues

### INTEREST EXPENSE RATIO

• Computation: Total farm interest expense / Gross revenues

### NET FARM INCOME FROM OPERATIONS RATIO

• Computation: Net farm income from operations / Gross revenues

Through recorded history, people have felt the need to measure performance and compare the measure to a standard. Generally, this measurement takes the form of some quantitative factor. Because financial reporting uses numbers, it becomes relatively easy to perform much of the measurement of business activity by the use of financial ratios of other financial measures. It is through these financial measures that one can systematically analyze a firm’s past performance. Assess the present financial position, and realistically determine the likely future performance. However, financial measures used in a vacuum are absolutely meaningless.

Financial measures enable the management of a firm to analyze past performance versus present performance, present performance versus budgeted performance, and a multi-year performance trend. When a firm is compared to itself, management and owners can very quickly identify the general trend. Care must be taken to not refine the measures used past the point where the accounting records realistically can support them.

In addition, financial measures permit the management of a firm to measure relative position of the firm within an industry group of similarly sized firms. It would seem reasonable that if the financial measures of Firm X are more advantageous relative to those of competing firms within that industry, Firm X should be considered doing better than most. Intuitively, this conclusion is quite sensible and generally will stand the user of such information in reasonably good stead. Care must be exercised when measuring a firm’s relative position within an industry. There have been times when the generally accepted wisdom of the industry has proven to be false. You, the user must decide whether or not the financial ratios generally being exhibited by the entire industry are reasonable or reflective of an industry experiencing unrealistic expectations.

When all else fails and you still have questions, this is the reason for the big bucks that are paid to the CPA’s of the world who so aptly take care of all of the accounting questions and problems and audits that we have. Please contact the state board of Certified Public Accountants for listings of agri-CPA’s availability in your area. Ask any of the local FSA people or check with your local extension service about those in your area. Even the folks at the coffee shop will have a suggestion!