by: Chris Zoller, Extension Educator, ANR, Tuscarawas County
The United States Department of Agriculture Economic Research Service (USDA-ERS) collects and summarizes an incredible amount of data about farm financial conditions. This article will discuss solvency and solvency ratios of U.S. farms.
Solvency is a measure of the ability of a farm to satisfy its debt obligations when due and is measured using the debt-to-equity ratio and debt-to-asset ratios. These ratios help determine whether, if your farm were sold, all debts would be paid.
The U.S. farm sector debt-to-equity (D/E) and debt-to-asset (D/A) ratios are expected to continue increasing. In 2020, ERS forecasts a debt-to-equity ratio of 15.7 percent, and a debt-to-asset ratio of 13.6 percent (Chart 1). These higher ratios indicate that more of the farm sector’s assets are financed by credit or debt relative to owner equity (D/E) and relative to total farm assets (D/A). While not as high as the ratios experienced during the 1980s, the concern is that these ratios are rising. The impact of this year’s shelter-in-place restrictions due to COVID-19, and associated supply chain issues are not reflected in this ERS data.
Getting Started
The first step in determining the ratios for your farm is to complete an annual balance sheet. The balance sheet lists all your assets and liabilities. Subtracting total farm liabilities from total farm assets results in the equity (net worth) of your farm business. See OSU Extension Fact Sheet ANR-64 (https://ohioline.osu.edu/factsheet/anr-64) for a detailed explanation of completing a balance sheet.
Calculating the Ratios
Debt to asset ratio – compares the amount of debt a farm has relative to total assets owned by the farm and is calculated by dividing total farm debt by total farm assets to arrive at a percentage. For example, a debt to asset ratio of 40 percent means that for every $1 in assets, the farm has 40 cents of debt. The Farm Financial Standards have identified the following general ranges:
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- Less than 30% is strong
- Between 30% and 60% is cautious
- More than 60% indicates vulnerability
However, for many farms, a D/A ratio higher than 40% can be unmanageable if the farm business is not profitable on a long-term basis.
Debt to equity ratio – is simply total farm debt divided by total farm equity (net worth) and compares how much of a farm is owned by the lender vs. the owner. The higher the number, the less likely creditors are willing to lend money. The desired number is less than 0.43 (43%). Anything over 1.5 indicates the farm is highly leveraged.
Example Farm
Mitchell Family Farms completed their annual balance sheet on January 1, 2020. The balance sheet lists the value of total farm assets at $2,475,000 and total farm liabilities of $600,000. Net worth/equity (assets – liabilities) equals $1,875,000.
To calculate the debt to asset ratio for Mitchell Family Farms, divide $600,000 (total farm debt) by $2,475,000 (total farm assets). This equals 24%, which is within the “strong” category identified by the Farm Financial Standards Council.
The debt to equity ratio is calculated by dividing $600,000 (total farm debt) by $1,875,000 (net worth or equity). The debt to equity ratio for Mitchell Family Farms is 32%. The is within the desired ratio of 43% suggested by the Farm Financial Standards Council.
Based solely on these two measures, Mitchell Family Farms is in a desirable financial position. However, it is important to evaluate more ratios to determine the overall financial health of the farm business.
Next Steps
After completing a balance sheet and making calculations, refer to the Farm Financial Standards Council benchmarks to compare your numbers with industry accepted standards. If the ratios are acceptable, continue managing to maintain the numbers and benchmark using these standards https://ffsc.org/wp-content/uploads/2012/06/FarmFinancialGuidelinesRatios1.pdf
If your ratios need improvement, focus on those that are in most need of change. Here are a few recommendations:
- Consult with your lender or Extension professional to analyze and discuss your ratios
- Contact the Ohio State University Extension Farm Business Analysis and Benchmarking Program for a complete analysis of your farm finances (https://farmprofitability.osu.edu/)
- Develop a plan to address shortcomings
- Have written goals
- Monitor progress
Summary
Financial management in agriculture is more critical today than it has been in many years. Devote time to your farm finances and reach out to professionals who are available to help you be successful.
References
Farm Financial Guidelines and Ratios, Farm Financial Standards Council, https://ffsc.org/wp-content/uploads/2012/06/FarmFinancialGuidelinesRatios1.pdf
Ratios and Measurements in Farm Finances, University of Minnesota, https://extension.umn.edu/farm-finance/ratios-and-measurements#solvency-796061
The Basics of a Farm Balance Sheet, Ohio State University Extension Fact Sheet ANR-64, https://ohioline.osu.edu/factsheet/anr-64
USDA-ERS, Forecast for Higher Solvency Ratios in 2020 Indicates that More of the Farm Sector’s Assets are Financed by Credit or Debt, https://www.ers.usda.gov/data-products/chart-gallery/gallery/chart-detail/?chartId=98316