' A&Lancaster Fanning, Saturday,’ June 8, 1991
f
F
A
R
MANAGEMENT
UNDERSTANDING
SOLVENCY
AND LIQUIDITY
MEASURES
Russel Powell
Business Management
Agent
Editor’s note: This second of
an eight-article series written by
the five Southeastern/Central
Penn State Extension Farm
Management Agents, covering
various farm profitability and
efficiency measurement tools
and ratios.
In these uncertain economic
times, lenders have become
increasingly cautious and may
require more financial information
than you have provided in the past
Their purpose is to carefully evalu
ate your financial situation and
judge your ability to meet loan
obligations. Solvency and liquidi
ty measures are two of the most
commonly used tools to evaluate
the financial health of a business.
Much of the information neces
sary to compute these measures is
Guernsey Breeders’
Journal Hires
Intern
REYNOLDSBURG, Ohio—
Priscilla Harvey of Vancouver,
Washington, recently joined the
Guernsey Breeders' Journal staff
as an intern.
Harvey assumed her full-time
position in May. She will assist
Journal staff with advertising and
feature stories. She will also assist
the Information Department with
news releases and promotional
efforts.
Harvey is to be a senior this fall
at Washington State University in
Puliman, Washington. She is to
graduate in May of 1992 with a
Bachelor of Science degree in
Agricultural Communications.
At Washington Slate Universi
ty, Harvey is a very active member
of the WSU Dairy Club and served
as president during her junior year.
She is also an active member of
Agriculture Communicators of
Tommonow (ACT) and currently
serves as PR Chairman.
Harvey is a 2-year member of
the Washington State University
Dairy Judging Team and placed
fourth overall in the Western Invi
tational Dairy Judging Contest in
Richmond, Utah, this spring. She
will be competing in the national
intercollegiate contest this fall.
Harvey was a 10-year member
of 4-H where she was involved in
showing registered Guernseys,
judging and giving demonstra
tions. She was a Guernsey Junior
Member and won several Guern
sey Youth awards. Harvey was
also the 1985 Clark County Dairy
Princess.
Harvey is the daughter of Mike
found on the balance sheet This
provides a “snapshot” of the finan
cial situation of the business at a
specific point in time. It should be
developed at the end of each finan
cial year by every farm manager.
Comparison of successive balance
sheets will then provide a general
indication of business progress.
Solvence
Net Worth
Solvency calculations begin
with a comparison of total assets
and liabilities. The difference is
net worth. A positive net worth
(assets greater than liabilities)
indicates that the business is sol
vent while a negative net worth
(liabilities greater than assets)
means that the business is
insolvent.
The net worth of a business
reflects owner equity and is a very
general indicator of the risk
involved in making a loan to that
business. A large net worth rela
tive to total assets means that a
Mhey equipment
COMPANY, INC.
loan would be well secured and the
risk of default small. A small ilet
worth could present an obstacle to
securing credit because the risk of
loss to the lender is greater.
There are numerous ratios used
in balance sheet analysis to evalu
ate solvency and liquidity. Howev
er, these ratios should only be used
as tools for an initial evaluation
and not to answer specific ques
tions about problems within the
business. They are only general
indicators pointing to a need for
further investigation.
The net capital ratio is a com
mon measure of solvency and is
calculated by dividing total assets
by total liabilities. A solvent busi
ness is one with a ratio of 1:1 or
higher (one dollar of assets for
each dollar of liabilities). A finan
cially healthy business should
have a net capital ratio of at least
2.5:1, indicating that owner equity
is at least 60 percent of all assets
used in the business.
The debt-equity ratio is a mea
sure of solvency that reflects the
relationship between borrowed
and owned (equity) capital and is
commonly used by lenders. It is
calculated by dividing total debt by
owner equity. A ratio of less than
1:1 indicates that the owner of the
business owns a larger share of that
business than the lender. One of
the best uses for this ratio is a com
parison from one year to another to
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asses the changes in debt over
time. As the ratio decreases, owner
equity increases. A financially
health business should have a debt
equity ratio of 2:3 (.67) or less, but
this will vary with the quality of
management, the source of income
and the level of profits.
Liquidity
A financially healthy business
will have a greater amount of cur
rent assets than current liabilities
(“current” indicates an impact on
the business within me year).
Generally current assets should at
least equal I.S times total current
liabilities.
This excess is needed to serve as
a financial cushion in case of a
rapid drop in the price of current
assets (such as a crop). A rapid
decrease in price of current assets
could destroy the liquidity of a
business if there are barely enough
current assets to cover current
liabilities.
The excess of current assets also
indicates good financial health
because the excess is the source of
working capital (the funds neces
sary for covering day to day
expenses).
A shortage of working capital
may mean borrowing additional
funds or liquidating longer-term
assets (i.e. machinery or land) to
cover current operating expenses.
Neither of these options are advis
able because borrowing additional
funds may take too long, and sell
ing other assets may reduce future
production capacity or the ability
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255 PLANE TREE
DRIVE
LANCASTER, PA 17603
(717) 393-5807
to borrow.
The current ratio measures cur
rent liabilities relative to total lia
bilities as follows:
Current Debt Ratio = Current
liabilities /Total liabilities
The current debt ratio indicates
the part of total debt that must be
repaid within a year. Al:5 ratio (or
.2) indicates that 20 percent of total
debt must be repaid within one
year. The higher the ratio, the grea
ter the drain on cash reserves and
the greater the risk of being unable
to meet current financial obliga
tions. A high ratio could indicate a
need to refinance to convert part of
the current debt into a longer-term
obligation. However, be careful
not to dig yourself into a deeper
hole by converting current debt
into long-term liabilities without a
realistic plan for repayment.
The current debt ratio must be
interpreted with care and probably
should be used only to put other
ratios in perspective because it
does not include net worth. For
example, an individual with
$500,000 net worth and $5,000 of
debt composed of $4,000 of cur
rent liabilities and sl,oooof longer
term liabilities would have a cur
rent debt ratio of 4:5 (.8) but is not
in immediate financial danger.
For more information about
financial analysis, contact your
county extension office for a copy
of “Farm Business Analysis: Key
to Pennsylvania Farm Profitabili
ty” (extension circular 375).
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Current Debt Ratio
Designers of
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