Slide Show #14Slide Show #14AGEC 430

Macroeconomics of Agriculture

Spring 2010

Handout #23Handout #23

Supplemental Slides enhancing this slide show. I will point to specific text from Handout #23 at the end of this show

Supplemental Slides enhancing this slide show. I will point to specific text from Handout #23 at the end of this show

Measures of LiquidityMeasures of Liquidity1. Current ratioCurrent ratio:• Current assets divided by current liabilities.• Demonstrates ability to cover scheduled current liabilities for the coming year out current assets and still have “cash” left over.• Should exceed 1.0exceed 1.0 to be technically liquid.• Some firms fail despite exceeding this hurdle.

Measures of LiquidityMeasures of Liquidity1. Current ratioCurrent ratio:• Current assets divided by current liabilities.• Demonstrates ability to cover scheduled current liabilities for the coming year out current assets and still have “cash” left over.• Should exceed 1.0exceed 1.0 to be technically liquid.• Some firms fail despite exceeding this hurdle.

2. Working capitalWorking capital:• Current assets minus current liabilities.• Expresses liquidity in dollars rather than ratio.• Should be positive.• Cash is King!Cash is King!

Liquidity TrendsLiquidity Trends

Current Ratio

0.00

0.501.00

1.50

2.00

2.503.00

3.50

4.00

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity TrendsLiquidity Trends

Current Ratio

0.00

0.501.00

1.50

2.00

2.503.00

3.50

4.00

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailedMinimumMinimum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity TrendsLiquidity Trends

Measures of SolvencyMeasures of Solvency1. Debt ratioDebt ratio:• Total debt divided by total assets.• Demonstrates ability to liquidate the firm, cover all liabilities out of all assets, and still have “cash” left over.• Should not exceed 0.50not exceed 0.50 to minimize financial risk exposure.• Some firms fail however at lower levels.

Measures of SolvencyMeasures of Solvency1. Debt ratioDebt ratio:• Total debt divided by total assets.• Demonstrates ability to liquidate the firm, cover all liabilities out of all assets, and still have “cash” left over.• Should not exceed 0.50not exceed 0.50 to minimize financial risk exposure.• Some firms fail however at lower levels.

2. Leverage ratioLeverage ratio:• Total debt divided by equity or net worth.• Often a credit standard in loan approval decisions.• Should not exceed 1.0not exceed 1.0 to minimize financial risk exposure.• Effects of rising interest rates.

Solvency TrendsSolvency Trends

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Solvency TrendsSolvency Trends

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MaximumMaximum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measures of ProfitabilityMeasures of Profitability

1. Rate of return on assetsRate of return on assets:• Net income plus interest divided by total assets.• Demonstrates the after-tax return to the total capital invested in the firm. • Should be positivepositive; the higher the better.

Measures of ProfitabilityMeasures of Profitability

1. Rate of return on assetsRate of return on assets:• Net income plus interest divided by total assets.• Demonstrates the after-tax return to the total capital invested in the firm. • Should be positivepositive; the higher the better.

2. Rate of return on equityRate of return on equity:• Net income divided equity.• Demonstrates the after-tax return on owner equity invested in the firm.• Should be positivepositive; the higher the better.

Profitability TrendsProfitability Trends

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Profitability TrendsProfitability Trends

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MinimumMinimum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Measure of Debt CoverageMeasure of Debt Coverage

1. Term Debt and Capital Lease Coverage RatioTerm Debt and Capital Lease Coverage Ratio:• Cash available from operations to cover scheduled payments (net income plus depreciation and interest payments less withdrawals) divided by scheduled principal and interest payments on term loans and capital leases.• After provision for taxes and withdrawals. • Should be greater than 1.0greater than 1.0. • Non-farm income often factored in by lenders.

Measure of Debt CoverageMeasure of Debt Coverage

1. Term Debt and Capital Lease Coverage RatioTerm Debt and Capital Lease Coverage Ratio:• Cash available from operations to cover scheduled payments (net income plus depreciation and interest payments less withdrawals) divided by scheduled principal and interest payments on term loans and capital leases.• After provision for taxes and withdrawals. • Should be greater than 1.0greater than 1.0. • Non-farm income often factored in by lenders.

2. Debt Burden RatioDebt Burden Ratio:• Total debt outstanding divided by net income.• Number of years required to retire total debt if net income remains constant and used entirely for this purpose• Should be lowlow; the lower the better.

Debt Repayment Capacity Debt Repayment Capacity

Net Cash Income-to-Total Debt

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Inverse of debt burden ratio

assuming use of depreciation

allowances to retire debt.

Inverse of debt burden ratio

assuming use of depreciation

allowances to retire debt.

Some Conclusions….Some Conclusions….• Indicators of Indicators of

growth/survival:growth/survival:– Increasing liquidity– Increasing solvency– Increasing debt

repayment capacity– Increasing profitability

Some Conclusions….Some Conclusions….• Indicators of Indicators of

potential failure:potential failure:– Declining liquidity– Declining solvency– Decreasing debt

repayment capacity– Decreasing profitability

Some Conclusions….Some Conclusions….• Indicators of Indicators of

growth/survival:growth/survival:– Increasing liquidity– Increasing solvency– Increasing debt

repayment capacity– Increasing profitability

• Indicators of Indicators of potential failure:potential failure:– Declining liquidity– Declining solvency– Decreasing debt

repayment capacity– Decreasing profitability

Liquidity Trends

Current Ratio

0.00

0.501.00

1.50

2.00

2.503.00

3.50

4.00

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity Trends

Current Ratio

0.00

0.501.00

1.50

2.00

2.503.00

3.50

4.00

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MinimumMinimum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Liquidity Trends

Solvency TrendsTotal Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Solvency TrendsTotal Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MaximumMaximum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Profitability Trends

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Profitability Trends

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

MinimumMinimum

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Debt Repayment Capacity Net Cash Income-to-Total Debt

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1 2 3 4 5

Year Before Failure

SurvivedSurvived

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Inverse of debt burden

ratio

Inverse of debt burden

ratio

Some Conclusions….Some Conclusions….• Indicators of Indicators of

growth/survival:growth/survival:– Increasing liquidity– Increasing solvency– Increasing debt

repayment capacity– Increasing profitability

• Indicators of Indicators of potential failure:potential failure:– Declining liquidity– Declining solvency– Decreasing debt

repayment capacity– Decreasing profitability

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Summary of Trends…Summary of Trends…

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Summary of Trends…Summary of Trends…

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Summary of Trends…Summary of Trends…

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

Net Cash Income-to-Total Debt

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1 2 3 4 5

Year Before Failure

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Summary of Trends…Summary of Trends…

#1:Historical Analysis#1:Historical AnalysisA look backwards like

the Beaver study.Comparison of current

performance with past performance.

Recommend doing this at the enterprise level as well as for the farm as a whole.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

1 2 3 4 5

Prior Years

#1:Historical Analysis#1:Historical Analysis

A look backwards like the Beaver study.

Comparison of current performance with past performance.

Recommend doing this at the enterprise level as well as for the farm as a whole.

Why is ROA falling?Why is ROA falling?

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

1 2 3 4 5

Prior Years

#2:Comparative Analysis#2:Comparative Analysis

Comparing current performance with similar operations like the Beaver study.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

#2:Comparative Analysis#2:Comparative Analysis

Comparing current performance with similar operations like the Beaver study.

Benchmark analysis at enterprise level when possible.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

#2:Comparative Analysis#2:Comparative Analysis

Comparing current performance with similar operations like the Beaver study.

Benchmark analysis at enterprise level when possible.

Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

#2:Comparative Analysis#2:Comparative Analysis

Comparing current performance with similar operations like the Beaver study.

Benchmark analysis at enterprise level when possible.

Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

#2:Comparative Analysis#2:Comparative Analysis

Comparing current performance with similar operations like the Beaver study.

Benchmark analysis at enterprise level when possible.

Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

#2:Comparative Analysis#2:Comparative Analysis

Comparing current performance with similar operations like the Beaver study.

Benchmark analysis at enterprise level when possible.

Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

#2:Comparative Analysis#2:Comparative Analysis

Comparing current performance with similar operations like the Beaver study.

Benchmark analysis at enterprise level when possible.

Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Your firmYour firm

BenchmarkBenchmark

Presentation ModelPresentation ModelThe model given to each presentation

team will calculate these financial ratios for you.

Your task will be to interpret these ratios for your business as conditions change in the Lower Slobovian economy.

Table appearing on one of the worksheets in the class model.Table appearing on one of the worksheets in the class model.

Four of the five graphs generated by the class model.Four of the five graphs generated by the class model.

Impact of a tighter monetary policy…what do you see?Impact of a tighter monetary policy…what do you see?

Weaker liquidityWeaker liquidity

Weaker profitabilityWeaker profitabilityWeaker debt coverageWeaker debt coverage

Weaker solvencyWeaker solvency

Impact of a combination of tighter monetary and fiscal policyImpact of a combination of tighter monetary and fiscal policy

Handout #23Handout #23

Here is the text in this handoutHere is the text in this handout

Handout #23 contains an example income statement, balance sheet and cash flow information used to calculate these and other ratios.

Handout #23 contains an example income statement, balance sheet and cash flow information used to calculate these and other ratios.

Another measure is the debt burden ratio, or the ratio of debt outstanding to net cash income. The higher the ratio, the greater the stress on net cash income to retire debt outstanding.