DEFINITION OF RATIOS

PROFITABILITY RATIOS

Rate of Return on Farm Assets (ROA)

Computation: Net farm income from operations plus farm interest payments less unpaid labor charge for operator and family divided by average total farm assets (fair market value).

Interpretation: This ratio measures the pre tax rate of return on farm assets and can be used to measure the effective utilization of assets on the profitability of the business.

Rate of Return on Farm Equity (ROE)

Computation: Net farm income from operations less unpaid labor charge for operator and family divided by average farm equity (fair market value).

Interpretation: This ratio relates the pre tax returns to the level of equity capital employed in the farm business. Caution should be used when interpreting this ratio. A high ratio, normally associated with a profitable farm, may indicate an under capitalized farm while a low ratio, which normally indicates an inefficient or unprofitable farm, may indicate a more conservative, high equity farm. This measure, like many of the other ratios, should be used in conjunction with other ratios when analyzing a farm business.

Profit Margin Ratio

Computation: Net farm income from operations plus farm interest payments less unpaid operator and family labor divided by value of farm production.

Interpretation: This ratio is an efficiency measure that shows the return to capital and management as a percent of adjusted gross production (VFP).

LIQUIDITY RATIOS

Current Ratio

Computation: Current assets divided by current liabilities.

Interpretation: This ratio is a measure of the farmers' ability to meet short run obligations without disrupting the ongoing business. The higher the ratio, the more "cushion" the farmer has in meeting his or her current obligations. This ratio may be limited by the quality of the assets and/or the ability to quickly convert the specific current assets into cash.

Current plus Intermediate Ratio

Computation: Current plus intermediate assets divided by current plus intermediate liabilities.

Interpretation: This ratio measures farmers' utilization of short and intermediate term assets as reserves relative to debt claims against these assets. Many contractually "short term" notes are actually longer term in the expected repayment period. Thus, the classification between short and intermediate may be somewhat arbitrary. Also, many farmers obtain most of their short and intermediate term financing from the same lender. This ratio supplies beneficial information on collateral availability and secondary repayment capacity for both the borrower and the lender.

Working Capital to Value of Farm Production

Computation: Working capital (Current assets - Current liabilities) divided by value of farm production (VFP)

Interpretation: Working capital (current assets - current liabilities) is a measure of the amount of funds available to purchase inputs after the sale of current assets and the payment of all current liabilities. Working capital compared to VFP relates the amount of working capital to the size of the operation. The higher the ratio, the more liquidity the farm operation has to meet current obligations. The ratio varies across farm types and other farmer characteristics.

Debt Servicing Ratio

Computation: Farm interest expense plus annual scheduled intermediate and long term principal payments divided by value of farm production.

Interpretation: The proportion of value of farm production that must be used to meet financing costs and debt obligations.

SOLVENCY AND COVERAGE RATIOS

Debt to Equity (leverage)

Computation: Total liabilities divided by net worth.

Interpretation: This ratio expresses the extent to which debt capital is combined with equity capital. It shows the inherent risk to creditors, but at the same time may reveal the farm's potential for future growth if operating earnings exceed the fixed commitments associated with debt.

Debt to Asset

Computation: Total debt divided by total assets (fair market value).

Interpretation: This ratio is another way of expressing the risk exposure of the farm business
(debt/(debt+equity)).

Interest Coverage

Computation: Net farm income from operations plus interest payments divided by interest expense.

Interpretation: This ratio is a measure of a farm's ability to meet interest payments. As the value of the interest coverage ratio increases, the farmer's exposure to financial risk decreases. The interest coverage ratio is analogous to an asset to debt ratio taken from the balance sheet. The coverage ratio relates asset returns to debt obligations for a period of time while the asset to debt ratio relates total assets to total debt at a point in time.


REPAYMENT CAPACITY

Term Debt and Capital Lease Ratio

Computation: (Net farm income from operations plus non-farm income plus depreciation plus interest on term debt plus interest on capital leases less income taxes less family living withdrawals) divided by annual scheduled principal and interest payments on term debt and capital leases

Interpretation: The measure provides a measure of the ability of the borrower to cover all term debt and capital lease payments. The greater the ratio, the greater the margin to meet all term debt and capital lease payments.


FINANCIAL EFFICIENCY RATIOS

Asset Turnover

Computation: Value of farm production divided by total average farm assets (fair market value).

Interpretation: This is a general measure of the farm's efficiency of asset utilization. The higher the ratio, the more effectively assets are used to generate revenue. This ratio typically shows wide variations across farm types.

Operating Expense Ratio

Computation: Total operating expenses less depreciation divided by value of farm production.

Interpretation: The relationship of operating expense to value of farm production. Measures the farm's efficiency of operating expense management. The measure typically varies by farm type.


Depreciation Expense Ratio

Computation: Total farm depreciation divided by value of farm production.

Interpretation: The relationship of depreciation expense to value of farm production. The measure typically varies by farm type and will vary from year to year, especially when accelerated tax depreciation methods are used to estimate depreciation.

Interest Expense Ratio

Computation: Total farm interest expense divided by value of farm production.

Interpretation: The relationship of interest expense to value of farm production. Often used as a measure of the financial risk of the farm operation.

NFI from Operations Ratio

Computation: Net farm income from operations divided by value of farm production.

Interpretation: A pre-tax efficiency measure that measures the return to labor, capital and management as a percent of value of farm production.