# Present Financial Position and Performance of the Firm s1

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## Handout #1

## Agricultural Economics 489/689

Handout #1

**Spring Semester 2009**

**John B. Penson, Jr.**

## Part I: Review of Concepts and Jargon

## A. Introduction to Terminology

Before proceeding with key topics in the financial analysis of an agricultural firm, we need to refresh your memory on key terminology and introduce you to others.

## Liquidity

Liquidity is generally defined as the ability to generate cash quickly to meet claims on the business without disrupting the ongoing operations of the business. There are three forms of liquidity: (1) asset liquidity, (2) credit liquidity and (3) cash flow liquidity.

Asset liquidity – the ability to convert assets to cash quickly to meet claims on the business without disrupting the ongoing operations of the business. If the firm can convert its current assets to cash, retire its current liabilities and have cash left over, the firm is said to be liquid. Assets that can be converted to cash quickly are referred to as current assets, and include financial instruments (cash itself, stocks and bonds and accounts and notes receivable) as well as non-financial assets like unsold production inventories and inventories of purchased inputs. Assets on a firm’s balance sheet are typically ordered in terms of their liquidity, which explains why cash appears first in the asset column of the balance sheet and land appears last. While land may be sold quickly, its sale will affect the ongoing nature of the firm’s business operations.

**Credit liquidity** – the ability to borrow cash quickly to meet claims on the business without disrupting the ongoing operations of the business. This concept is related to the firm’s unused credit reserves, or the maximum amount of credit lenders will typically extend to a firm based upon its debt/equity structure.

**Cash flow liquidity** – the first two measures of liquidity are typically based upon balance sheet evaluations at a specific point in time. Cash flow liquidity on the other hand is a periodic measure of liquidity, usually monthly. The firm’s monthly cash flow statement reflects the cash flows available and cash flows required during the month. If the ensuing difference between these totals, or net cash balance, is positive, the firm is liquid during that month.

## Solvency

Solvency refers to the ability of the firm to convert all its assets to cash, retire all of its liabilities and have cash left over. Note the emphasis on all assets and all liabilities as opposed to current assets and current liabilities when we discussed the concept of asset liquidity described above.

Profitability

Profitability refers to the ability of a firm to generate a level of revenue that exceeds its total costs of production. The bottom line of the firm’s income statement reflects the net income of the firm, one of many measures of profitability. Care must be taken when assessing profitability over time to account for changes in the purchasing power of money. Nominal net income refers to net income not been adjusted for inflation while real net income reflects adjustments for changes in the purchasing power of the firm’s profits from one year to the next.

Economic efficiency

Economic efficiency refers to the ability of the firm to use its resources to achieve a desired result with little or no wasted effort or expense. This differs from technical efficiency or productivity (i.e., yield per acre) which does not take prices or unit costs of production into account.

Debt repayment capacity

Debt repayment capacity refers to the ability of the firm to meet its scheduled term debt and capital lease payments and have cash left over. This concept is closely linked to the concept of unused credit reserves in the literature, or the difference between the maximum capacity to borrow as viewed by lenders and the amount of borrowed capital the firm has already undertaken.

Present vs. future value

Present value refers to the value today of a sum of money or stream on payments to be received in the future, discounted back to the present using an appropriate required rate of return. Future value, on the other hand, refers to the value at a specific future date of a sum of money or stream of payments (perhaps to an annuity).

Risk

The possible variation associated with the expected return or value measured by the standard deviation or coefficient of variation. There are many forms of risk, including price risk, interest rate risk, yield risk, political risk, relationship risk, etc.). This collectively is often referred to as business risk, or the relative dispersion or variability in the firm’s expected earnings. This differs then from financial risk, or the potential loss in equity associated with the use of leverage (debt and equity capital). Finally, risk can also be classified as systematic risk (or non-diversifiable risk) and unsystematic risk (the portion of the variation in investment returns that cannot be eliminated by diversification).

Physical vs. financial capital

Physical capital refers to those assets on the firm’s balance sheet that are not in the form of financial instruments. Examples include inventories of unsold production, machinery and equipment, inventories of production inputs, trucks, buildings and land. Financial capital, on the other hand, typically refers to financial instruments (cash, stocks and bonds) as well as the equity capital the owners firm have invested in the firm.

Explicit vs. implicit costs

Explicit costs are those expenses such as wages paid to hired labor where a cash payment to others is required. Implicit costs on the other hand are those expenses such as depreciation or opportunity costs that do not involve the payment of money.

Variable vs. fixed expenses

Variable expenses are those expenses that vary with the level of production. Fuel and fertilizer expenses are two examples. Fixed expenses, on the other hand, are those expenses that do not vary with the level of production. A property tax payment, which must be paid even if output of the firm is zero, is a form of fixed expenses.

Optimal capital structure

This refers to the capital structure that maximizes the firm’s composite cost of capital for a given amount of debt and equity capital. This will be influenced by the relative cost of financing capital acquisition opportunities with debt and equity capital.

Capital budgeting

The decision making process associated with investment in fixed assets (machinery and equipment, land and buildings. There are various forms of capital budgeting methods available, including the payback period method, the profitability index method, the internal rate of return method and the net present value method. Each will be covered in depth later in this booklet.

Financial analysis

Financial analysis refers to the assessment of a firm’s financial performance, both from a historical perspective and a futuristic perspective. The overall objective is to determine the firm’s existing financial strengths and weaknesses, and to develop/evaluate strategies that affect the firm’s future performance. Both perspectives involve the use of financial ratios as performance indicators as well as decision aides or analytical tools to evaluate decisions to expand/contract enterprises in the firm.

B. Key Financial Indicators to Track

Measures of liquidity

There are several approaches to measuring the liquidity of a firm depending on whether you are talking about asset liquidity, credit liquidity or cash flow liquidity.

Two common measures of asset liquidity are the current ratio and the level of working capital. The current ratio is given by:

(1) Current ratio = current assets ¸ current liabilities

where current assets are those assets that can be converted to cash within the year and current liabilities are those liabilities that are due within the year. If this ratio is greater than 1.0, the firm is said to be liquid, or able to retire all its current liabilities with its current assets and have cash left over. Studies have shown, however, that the firm can be liquid and still fail. Other ratios (acid test ratio and cash ratio) represent variations of equation (1), where specific categories of current assets are excluded from the numerator.

The level of working capital is given by:

(2) working capital = current assets – current liabilities

If the level of working capital is positive, then the firm has sufficient current assets to cover all its current liabilities and still have cash left over. This term is sometimes referred to as net working capital.

**Measures of solvency**

There are numerous approaches to measuring the solvency of the firm. They all involve balance sheet data and are transformations of one another. These measures include the debt ratio, the net worth ratio, the asset ratio and the leverage ratio. Each is defined as follows:

(3) debt ratio = total debt or liabilities ¸ total assets

(4) net worth ratio = total net worth or equity ¸ total assets

(5) asset ratio = total assets ¸ total debt or liabilities

(6) leverage ratio = total debt or liabilities ¸ total net worth or equity

Suppose the firm’s total assets are $100 and its total debt or liabilities are $25. In this case the firm’s debt ratio would be 0.25, its net worth ratio would be 0.75, its asset ratio would be 4.0, and its leverage ratio would be 0.33. All ratios indicate this firm would be solvent; its could convert all of its assets ($100) to cash, retire all of its liabilities ($25), and still have cash left over ($75).

**Measures of profitability**

In addition to the level of net income, which we said earlier is a measure of profitability, other commonly-used measures exist. These include the rate of return on assets (ROA) and the rate of return on equity capital (ROE). Another measure is the net or operating profit margin. These measures can be defined as follows:

(7) Rate of return on assets = (net income + interest expense) ¸ total assets

(8) Rate of return on equity = net income ¸ total equity or net worth

(9) Net profit margin = (EBIT – tax) ¸ total revenue

where EBIT represents earnings before interest and tax payments, or net income minus interest and tax payments. Suppose a firm had the following characteristics: $100 in total assets, $25 in total debt, total revenue of $200, interest expenses of $5, taxes of $10 and other expenses totaling $130. The firm’s net income would be $55 (i.e., $200 - $130 - $5 - $10) and its EBIT would be $70 (i.e., $55 + $5 +$10). This would result in a ROA of 60% (i.e., {[$55 + $5]¸$100}´100); an ROE of 73% (i.e., [$55¸$75] ´100), and a net profit margin of 30% (i.e., {[$70 - $10] ¸ $200} ´100).

Measures of economic efficiency

Like the other financial indicators, there are a variety of measures of economic efficiency used by financial analysts. These include a number of expense ratios (interest expense ratio, variable expense ratio, depreciation expense ratio) as well as several turnover ratios (total asset turnover and fixed asset turnover). These ratios are defined as follows:

(10) interest expense ratio = interest expenses ¸ total revenue

(11) variable expense ratio = total variable expenses ¸ total revenue

(12) depreciation expense ratio = depreciation expenses ¸ total revenue

(13) total asset turnover ratio = total revenue ¸ total assets

(14) fixed asset turnover ratio = total revenue ¸ fixed assets

Assume the firm’s depreciation expense is $20 and its total fixed assets are $85. Using the example discussed with respect to measures of profitability, the firm’s interest expense ratio would be 2.5% (i.e., [$5¸$200] ´100), its variable expense ratio would be 55% (i.e., {[$130 - $20] ¸$200}´100), its depreciation expense ratio would be 10% (i.e., [$20¸$200] ´100), its total asset turnover ratio would be 2.0 (i.e., $200¸$100) and its fixed asset turnover ratio would be 2.35 (i.e., $200¸$100). This means the firm’s interest expenses, variable expenses and depreciation expenses are 2.5%, 55% and 10% of every dollar of total revenue, respectively. The firm furthermore turns over its total assets twice each year and fixed assets 2.35 times each year.

**Measures of debt repayment capacity**

Finally, measures of debt repayment capacity include term debt and capital lease coverage ratio, times interest earned ratio, and debt burden ratio to name a few. They are calculated as follows:

(15) Term debt and capital

lease coverage ratio

(16) Times interest earned ratio = (EBIT – taxes) ¸ scheduled interest payments

(17) Debt burden ratio = total debt outstanding ¸ net income

The financial indicators in equations (15) and (16) should be greater than one. This would indicate the firm has, at minimum, the capability to service their commitments as scheduled. Obviously the greater these ratios are, the greater the comfort zone for the lender. Equation (17) indicated the number of periods needed to retire total debt outstanding if net income was used entirely for this purpose. If the net income statistic used comes from an annual income statement, then this ratio would reflect the number of years necessary to retire the firm’s entire debt. While this may reflect the eventual application of net income, it does indicate to a lender the firm’s ability to retire debt from operations.