I have the most enjoyable privilege to drive my young granddaughter around Winnipeg, where she and I live. Like every youngster her age, she’s super observant of things and not shy in telling me what to do and where to turn to get to our destination. She’ll tell me when she thinks I’ve gone the wrong way and keep reminding me of my navigation mistakes. And then miraculously … to her I’m sure … when we arrive, she simply says ‘oh … look … we’re here’!
She’s also very attentive when we’re approaching or stopped at a traffic signal. She’s quick to remind me that ‘red means stop’ and ‘green means go’. And she’s impatient if when the light changes to green, I don’t start moving right away. She doesn’t know this but she’s a lot like her mother was at that age, so the apple indeed doesn’t fall too far from the tree!
Many of you will have seen illustrations for farm businesses that express financial performance ratios as being red/amber/green. Same format as a stop light but obviously used differently. I’ve used the format in workshops and university classes I’ve taught, and with farm families to bring perspective to the significance of the different ratios that present a picture of a farm’s financial situation.
At a traffic light, your options and the information presented is straightforward. If all motorists respected the rules, traffic would flow relatively smoothly. The risks increase when motorists don’t give enough respect to the amber or red signals.
What about for a farm? I think the same can be said for farms and the ‘colours’ of their financial ratios. There certainly are risks associated with financial performance where the given ratio is in the amber or red zone. But are there risks associated with the green lights? I think so, as I note below.
I’m asked quite often how I look at a farm’s financial performance. I will always look at these ratios, in this order …
- Gross margin
- Working capital percentage
- Debt to equity
- Debt servicing
- Net operating profit margin
- Operating efficiency margin
I don’t have enough room in this article to elaborate on why I use these performance indicators, or how they’re calculated. In general, they speak to efficiencies in operations, cashflow strengths or weaknesses, risks associated with debt and the consideration to capital investment.
The tricky part about using ratios to analyze a farm’s financial performance … and much different from a traffic light where there’s only one signal to pay attention to … is that each ratio has its own red/amber/green ‘signal’. And the ratios all collectively tell you something about your farm’s financial performance. You can have red, amber and green coloured signals at the same time albeit for different ratios.
Which ones do you pay attention to … and when … is a key question. I think for many farmers, the answer being ‘it depends’ can be frustrating. But it’s a fact. What ratios with what colours and when they should be heeded depends on what’s happening on the farm at any given time. Is the farm expanding, transitioning, diversifying? Has there been consecutive years of adverse weather? Are there other factors that are impacting on financial performance? Both good and bad? Financial performance does in fact ‘depend’.
A ratio with a ‘red’ signal usually warrants attention to understand –
- Why the particular ratio is in the ‘red’ zone.
- What the significance of it is to a farm’s overall financial performance.
- What can be done about it, and when.
A ‘green’ indicator for any given ratio is easier to understand. All systems go in a sense. You’re stopped at a traffic signal and the light turns green, you proceed. But how? Is it a full-throttle sort of thing or a more cautious start?
As I think about this, I don’t recall my granddaughter telling me what she thinks the ‘amber’ traffic signal light is for. I guess for her it’s either stop or get going! For farms though, given their financial realities, I wonder if a preferred approach to a ‘green’ signal would be to proceed but at more of an ‘amber’ speed.
If the green signal that you’re looking at in the above ratios is the working capital percentage, that’s a good thing because it’s indicating that your liquidity is strong. In these economic times, my advice is to be very careful to not doing something that will significantly weaken your working capital position. Carefully analyze the impact on your working capital percentage from an investment opportunity you may have in front of you. If making the investment will take your working capital percentage ratio into the ‘amber’ zone, proceed cautiously. If one or more of the ratios noted above are in the amber zones, my suggestion is to be even more cautious.
The age-old saying that ‘cash is king’ is more relevant than ever.
If you would like to speak to one of our consultants about this topic, contact us.