Warnings, Watches and Clear Blue Skies; Forecasting with Ratios and Risk Ratings
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1 Warnings, Watches and Clear Blue Skies; Forecasting with Ratios and Risk Ratings Tim Ohlde, CEO Country Banker Systems LLC Clyde, Kansas Two Current Ag Industry Issues Carry Over Debt Tight Cash Flows How Do You Respond? What lines of defense are there for these issues? What type of analysis is a must have? How do you help your customers survive and thrive? WBA Agricultural Bankers Conference 1
2 Five Powerful Ratios Liquidity: Working Capital as a percentage of expense Solvency: Debt to Asset Profitability: ROA Financial Management/Efficiency: Operating Expense Efficiency Repayment: Term Debt Coverage Ratio Current Ratio is Phasing Out Replaced by More Tangible Measures WBA Agricultural Bankers Conference 2
3 Working Capital as a % of Expense FFSC Recommends Gross Revenue Expense Preferred as it is Less Variable Measure of Current Equity in Operating Cycle Two Components of Working Capital Owners Investment or Equity Lender s Debt Components of Working Capital Operator Capital Borrowed Capital Working Capital = Current Assets Current Liabilities Working Capital is the Farmer s Equity on the Current Section of the Balance Sheet WBA Agricultural Bankers Conference 3
4 Working Capital as part of the Operating Cycle Comparison to Operating Expense Dollars in the Operating Cycle Supplied by the Farmer Operating Cycle Farmer's Working Capital Total Expense The Dynamic Duo Working Capital to Expense Ratio Properly Slotted 12/31/20XX Balance Sheet Powerful Measure or Indicator of Liquidity You know the (estimated) LOC Needed for Coming Year Different from the 1980 s : Today s Operations Must SELF-FUND Liquidity WBA Agricultural Bankers Conference 4
5 Working Capital to Operating Expense Ratio Working Capital Operating Expense < than 10% RED 10% to 30% YELLOW > than 30% GREEN Calculating Working Capital as a Percentage of Expense FARMER 1 - Liquidity Ratios Super 4 Super 3 Super 2 Super 1 Current Assets $790,000 $692,000 $746,000 $315,000 Total Assets $4,205,000 $3,691,000 $3,494,000 $3,082,000 Current Liabilities $750,000 $620,000 $690,000 $287,000 Total Liabilities $1,965,000 $1,614,000 $1,761,000 $1,700,000 Owner Equity $2,240,000 $2,077,000 $1,733,000 $1,382,000 Gross Revenue $1,160,000 $1,005,000 $1,045,000 $685,000 Total Expenses $1,079,000 $993,000 $770,000 $766,000 LIQUIDITY CURRENT RATIO (CA/CL)~ WORKING CAPITAL (CA-CL) $40,000 $72,000 $56,000 $28,000 Working Capital (Beginning) $72,000 $56,000 $28,000 $14,000 Working Capital as % of EXPENSE 3.71% 7.25% 7.27% 3.66% (WC/TE) Working Capital as % of GROSS 3.45% 7.16% 5.36% 4.09% REVENUE (WC/GR)~ Working Capital Change from Previous YR ($32,000) $16,000 $28,000 $14,000 WBA Agricultural Bankers Conference 5
6 FARMER 1 - Liquidity Ratios Post 4 Post 3 Post 2 Post 1 Current Assets $595,000 $882,000 $1,034,000 $1,000,000 Total Assets $4,325,000 $4,747,000 $5,076,000 $5,075,000 Current Liabilities $480,000 $542,000 $420,000 $383,000 Total Liabilities $1,698,000 $1,871,000 $1,923,000 $2,010,000 Owner Equity $2,627,000 $2,876,000 $3,153,000 $3,065,000 Gross Revenue $1,050,000 $997,000 $1,050,000 $1,190,000 Total Expenses $1,152,000 $1,136,000 $1,105,000 $1,143,000 LIQUIDITY CURRENT RATIO (CA/CL)~ WORKING CAPITAL (CA-CL) $115,000 $340,000 $614,000 $617,000 Working Capital (Beginning) $340,000 $614,000 $617,000 $40,000 Working Capital as % of EXPENSE 9.98% 29.93% 55.57% 53.98% (WC/TE) Working Capital as % of GROSS 10.95% 34.10% 58.48% 51.85% REVENUE (WC/GR)~ Working Capital Change from Previous YR ($225,000) ($274,000) ($3,000) $577,000 There is Liquidity, But... Does It Count? Quality Matters What Does Quality Look Like? Cash On-Hand: 60 Days Operating Expenses or Equal to Two Years of Greatest Losses Risk Management: Income Protection Expense Protection Interest Rates Pre-Paid Expenses: An Unsecured Loan to a Vendor Accounts Receivable: Dependent on Quality/Financial Integrity of Vendor WBA Agricultural Bankers Conference 6
7 Solvency = Measure of Debt or Leverage in an Operation Three Views... Debt:Asset Total Liabilities Divided by Total Assets Equity:Asset Total Equity Divided by Assets Leverage Ratio Total Liabilities Divided by Owner Equity Lesson from the 80 s Differences from the 80 s According to the Postmortem - The #1 commonality of failed operations... Debt to Asset Ratio of 50% or Greater Today there are fewer operations Operations have higher concentrations of debt Solvency Ratio Samples Solvency Year 1 Year 2 Year 3 Year 4 Total Assets $2,176,650 $1,791,850 $1,717,300 $1,421,120 Total Liabilities $976,900 $871,600 $878,050 $845,850 Owner Equity $1,199,750 $920,250 $839,250 $575,270 Debt to Asset Ratio (TL/TA) 44.88% 48.64% 51.13% 59.52% Equity/Asset Ratio (OW/TA) 55.12% 51.36% 48.87% 40.48% Leverage Ratio (TL/OE) 81.43% 94.71% % % WBA Agricultural Bankers Conference 7
8 Critical - Benchmark and Monitor Trend Recognize Limitations 2. Utilize in Conjunction with Profitability 3. Recognize Influence of Balance Sheet Accuracy Debt to Asset = Total Farm Liability / Total Farm Asset BENCHMARK: <3O% 30% TO 70% >70% Equity to Asset = Total Farm Equity / Total Farm Asset BENCHMARK: >7O% 30% TO 70% <30% Profitability Ratio ROA = Return on Assets Net Farm Income from Operations (NFIFO) less Family Living/Operator Management Fee plus Interest divided by Average Assets WBA Agricultural Bankers Conference 8
9 Profitability Sample Ratios Return on Assets Year 1 Year 2 Year 3 Year 4 Average Assets (AA) $1,984,250 $1,754,575 $1,569,210 $1,421,120 Average Liabilities (AL) $924,250 $874,825 $861,950 $845,850 Average Equity (AE) $1,060,000 $879,750 $707,260 $575,270 Gross Revenue (GR) $956,250 $826,500 $887,000 $558,500 Total Expenses (TE) $756,800 $769,500 $715,020 $582,000 Interest Expense (IE) $49,250 $48,000 $41,500 $65,000 Net Farm Income from Operations (NIFO) = (GR TE) $199,450 $57,000 $171,980 $23,500 Family Living/Operator Management $72,500 $70,350 $65,000 $62,500 NIFO Fam Living/Op MGMT + IE = (2) $176,200 $34,650 $148,480 $21,000 Return on Assets (2/AA)* 8.88% 1.97% 9.46% 1.48% You Can't Go Broke Making a Profit! Profitability Ratio Benchmarks Return on Assets: (Mostly Owned) (NFIFO* + Farm Interest Expense Operator Management Fee)/Average Total Farm Assets BENCHMARK: >5% 1% TO 5% <1% Return on Assets: (Mostly Rented/Leased) (NFIFO* + Farm Interest Expense Operator Management Fee)/Average Total Farm Assets BENCHMARK: >12% 3% TO 12% <3% WBA Agricultural Bankers Conference 9
10 Financial Management/Efficiency Ratio Operating Expense Ratio = Total Operating Expenses (Excluding Depreciation and Interest) divided by Gross Revenue In Essence How many cents of operating cost does it take to produce a dollar of Gross Revenue? What does the operation spend to produce a greenback or buck? Farmer 1 Operating Expense Efficiency Ratio Pre-Super FARMER 1 Pre 1 Pre 2 Pre 3 Gross Revenue (GR) $400,000 $505,000 $693,000 Interest Expense (IE) $20,000 $45,000 $30,000 Depreciation Expense (DE) $115,000 $134,000 $150,000 Total Expenses (TE) $396,000 $560,000 $681,000 Net Farm Income From Operations (NFIFO)=(GR-TE) $4,000 ($55,000) $12,000 Operating Expense (OE)=(TE-IE-DE) $261,000 $381,000 $501,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 65.25% 75.45% 72.29% 71.00% WBA Agricultural Bankers Conference 10
11 Farmer 1 Operating Expense Efficiency Ratio - Super FARMER 1 Super 1 Super 2 Super 3 Gross Revenue (GR) $1,050,000 $985,000 $1,170,000 Interest Expense (IE) $51,000 $65,000 $63,000 Depreciation Expense (DE) $225,000 $390,000 $300,000 Total Expenses (TE) $768,000 $998,000 $1,086,000 Net Farm Income From Operations (NFIFO)=(GR-TE) $282,000 ($13,000) $84,000 Operating Expense (OE)=(TE-IE-DE) $492,000 $543,000 $723,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 46.86% 55.13% 61.79% 54.59% Farmer 1 Operating Expense Efficiency Ratio Post Super FARMER 1 Post 1 Post 2 Post 3 Gross Revenue (GR) $1,150,000 $1,000,000 $1,040,000 Interest Expense (IE) $115,000 $85,000 $85,000 Depreciation Expense (DE) $225,000 $375,000 $320,000 Total Expenses (TE) $1,135,000 $1,137,000 $1,142,000 Net Farm Income From Operations (NFIFO)=(GR-TE) $15,000 ($137,000) ($102,000) Operating Expense (OE)=(TE-IE-DE) $795,000 $677,000 $737,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 69.13% 67.70% 70.87% 69.23% WBA Agricultural Bankers Conference 11
12 Farmer 2 Operating Expense Efficiency Ratio Pre Super FARMER 2 Pre 1 Pre 2 Pre 3 Gross Revenue (GR) $445,000 $490,000 $555,000 Interest Expense (IE) $47,000 $39,000 $49,000 Depreciation Expense (DE) $30,000 $43,000 $49,000 Total Expenses (TE) $435,000 $409,000 $495,000 Net Farm Income From Operations (NFIFO)=(GR-TE) $10,000 $81,000 $60,000 Operating Expense (OE)=(TE-IE-DE) $358,000 $327,000 $397,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 80.45% 66.73% 71.53% 72.91% Farmer 2 Operating Expense Efficiency Ratio - Super FARMER 2 Super 1 Super 2 Super 3 Gross Revenue (GR) $415,000 $500,000 $780,000 Interest Expense (IE) $79,000 $68,000 $50,000 Depreciation Expense (DE) $44,000 $45,000 $105,000 Total Expenses (TE) $404,000 $453,000 $508,000 Net Farm Income From Operations (NFIFO)=(GR-TE) $11,000 $47,000 $272,000 Operating Expense (OE)=(TE-IE-DE) $281,000 $340,000 $353,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 67.71% 68.00% 45.26% 60.32% WBA Agricultural Bankers Conference 12
13 Farmer 2 Operating Expense Efficiency Ratio Post Super FARMER 2 Post 1 Post 2 Post 3 Gross Revenue (GR) $280,000 $490,000 $465,000 Interest Expense (IE) $30,000 $56,000 $56,000 Depreciation Expense (DE) $75,000 $48,000 $48,000 Total Expenses (TE) $466,000 $453,000 $453,000 Net Farm Income From Operations (NFIFO)=(GR-TE) ($186,000) $37,000 $12,000 Operating Expense (OE)=(TE-IE-DE) $361,000 $349,000 $349,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ % 71.22% 75.05% 91.74% Farmer 3 Operating Expense Efficiency Ratio Pre Super FARMER 3 Pre 1 Pre 2 Pre 3 Gross Revenue (GR) $230,000 $225,000 $328,000 Interest Expense (IE) $20,000 $15,000 $24,000 Depreciation Expense (DE) $25,000 $40,000 $34,000 Total Expenses (TE) $206,000 $208,000 $263,000 Net Farm Income From Operations (NFIFO)=(GR-TE) $24,000 $17,000 $65,000 Operating Expense (OE)=(TE-IE-DE) $161,000 $153,000 $205,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 70.00% 68.00% 62.50% 66.83% WBA Agricultural Bankers Conference 13
14 Farmer 3 Operating Expense Efficiency Ratio - Super FARMER 3 Super 1 Super 2 Super 3 Gross Revenue (GR) $473,000 $565,000 $467,000 Interest Expense (IE) $0 $21,000 $10,000 Depreciation Expense (DE) $33,000 $70,000 $150,000 Total Expenses (TE) $259,000 $357,000 $410,000 Net Farm Income From Operations (NFIFO)=(GR-TE) $214,000 $208,000 $57,000 Operating Expense (OE)=(TE-IE-DE) $226,000 $266,000 $250,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 47.78% 47.08% 53.53% 49.46% Farmer 3 Operating Expense Efficiency Ratio Post Super FARMER 3 Post 1 Post 2 Post 3 Gross Revenue (GR) $270,000 $365,000 $327,000 Interest Expense (IE) $23,000 $15,000 $11,000 Depreciation Expense (DE) $109,000 $110,000 $35,000 Total Expenses (TE) $440,000 $412,000 $288,000 Net Farm Income From Operations (NFIFO)=(GR-TE) ($170,000) ($47,000) $39,000 Operating Expense (OE)=(TE-IE-DE) $308,000 $287,000 $242,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ % 78.63% 74.01% 88.90% WBA Agricultural Bankers Conference 14
15 Farmer 4 Operating Expense Efficiency Ratio Pre Super FARMER 4 Pre 1 Pre 2 Pre 3 Gross Revenue (GR) $240,000 $375,000 $280,000 Interest Expense (IE) $25,000 $16,000 $37,000 Depreciation Expense (DE) $25,000 $37,000 $27,000 Total Expenses (TE) $233,000 $362,000 $262,000 Net Farm Income From Operations (NFIFO)=(GR-TE) $7,000 $13,000 $18,000 Operating Expense (OE)=(TE-IE-DE) $183,000 $309,000 $198,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 76.25% 82.40% 70.71% 76.45% Farmer 4 Operating Expense Efficiency Ratio - Super FARMER 4 Super 1 Super 2 Super 3 Gross Revenue (GR) $1,250,000 $1,230,000 $1,245,000 Interest Expense (IE) $62,000 $36,000 $65,000 Depreciation Expense (DE) $150,000 $110,000 $224,000 Total Expenses (TE) $672,000 $819,000 $1,071,000 Net Farm Income From Operations (NFIFO)=(GR-TE) $578,000 $411,000 $174,000 Operating Expense (OE)=(TE-IE-DE) $460,000 $673,000 $782,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 36.80% 54.72% 62.81% 51.44% WBA Agricultural Bankers Conference 15
16 Farmer 4 Operating Expense Efficiency Ratio Post Super FARMER 4 Post 1 Post 2 Post 3 Gross Revenue (GR) $990,000 $1,006,000 $1,048,000 Interest Expense (IE) $66,000 $57,000 $198,000 Depreciation Expense (DE) $188,000 $111,000 $178,000 Total Expenses (TE) $1,238,000 $892,000 $1,274,000 Net Farm Income From Operations (NFIFO)=(GR-TE) ($248,000) $114,000 ($226,000) Operating Expense (OE)=(TE-IE-DE) $984,000 $724,000 $898,000 Average: OPERATING EXPENSE RATIO (OE/GR)~ 99.39% 71.97% 85.69% 85.68% Operating Expense Efficiency Ratio: Management & Resource Base Indicator (MxR) 2 Range does not Change Great Benchmark for Pro Forma Cash Flows To Become More Efficient: Significant Management Change Resource Composite Change Adoption of New Practice Operators Love this Ratio! Use to Build Value with Customers Difference from the 80s Today s Operation Cost Structure is Substantially Higher WBA Agricultural Bankers Conference 16
17 Financial Efficiency Ratio Operating Expense/Revenue Ratio: (Mostly Owned) Operating Expense [excluding interest and depreciation]/ Gross Revenue BENCHMARK: <65% 65% TO 80% >80% Operating Expense/Revenue Ratio: (Mostly Rented/Leased) Operating Expense [excluding interest and depreciation]/ Gross Revenue BENCHMARK: <75% 75% TO 85% >85% Repayment Ratio: Term Debt Coverage Ratio Calculation: NFIFO plus Non-Farm Revenue equals Total Income Available (TIA) plus Depreciation & Interest equals Total Earnings Available (TEA) less Income Taxes & Family Living Costs equals Capacity Available for Debt Service/New Investments (CAP) divided by the total of Term Debt Principal Paid plus Interest equals Term Debt Coverage Ratio% WBA Agricultural Bankers Conference 17
![, Capital Lse Pymts (P +IE) $66,500 $105,150 $90,065 $200,000 CAPITAL REPLACEMENT & TERM DEBT MARGIN (CAP [P+IE]) $25,700 $59,250 $3,185 $152,750 TERM DEBT LEASE COVERAGE RATIO (CAP/[P+IE])~](/docs-images/95/126094521/images/18-13.jpg "138.65% 156.35% 103.54% 23.63% Repayment Insufficient?")
18 Repayment Sample Ratios Repayment Anaysis Year 1 Year 2 Year 3 Year 4 Net Farm Income from Operations (NIFO) $15,000 $45,950 $19,000 $23,500 Non Farm Income (NFI) $23,500 $8,000 $16,000 $12,000 TOTAL INCOME AVAILABLE (NIFO +NFI) $8,500 $53,950 $35,000 $11,500 Depreciation Epense (DE) $138,500 $139,500 $89,500 $55,000 Interest Expense (IE) $22,000 $47,500 $37,500 $65,000 TOTAL EARNINGS AVAILABLE (TIA+DE+IE) $169,000 $240,950 $162,000 $108,500 Income Tax $4,300 $6,200 $3,750 $1,250 Family Living/Op Mgmt Fee $72,500 $70,350 $65,000 $62,500 Capacity Available for Debt, New Investment (CAP) $92,200 $164,400 $93,250 $47,250 Principal Term & Cap Lease Payments (P) $44,500 $57,650 $52,565 $135,000 Total Interest, Princ., Capital Lse Pymts (P +IE) $66,500 $105,150 $90,065 $200,000 CAPITAL REPLACEMENT & TERM DEBT MARGIN (CAP [P+IE]) $25,700 $59,250 $3,185 $152,750 TERM DEBT LEASE COVERAGE RATIO (CAP/[P+IE])~ % % % 23.63% Repayment Insufficient? Look at These Key Areas - Farm Income Farm Expenses Personal Income Personal Living/Operator Management Fee Asset Evaluation Debt Restructure WBA Agricultural Bankers Conference 18
19 The Big Three to Monitor Liquidity: Working Capital as a percentage of Total Operating Expense Financial Management/Efficiency: Operating Expense Efficiency Repayment: Term Debt Repayment Capacity Ratios are the Foundation For Effective Risk Rating WBA Agricultural Bankers Conference 19
20 A good Livestock Judger uses a System, Lenders need a System for Evaluating Loan Quality Guidelines for Implementing or Updating a System Phase In the Introduction Tweak the Old System in Phases Use Guidelines from Dr. Kohl, Virginia Tech Balance the metrics, no single criteria exceeds 25% of the total risk rating At least 90% objective metrics WBA Agricultural Bankers Conference 20
21 Deciding What to Include No more than 7 Equal Weight to Balance Statement and Income Statement items Equalize the Source of Ratios Select Ratios calculated from Balance Statement information Income Statement information Combination of both prevents one or the other from dominating the risk rating Confirm that no single ratio is weighted too heavily WBA Agricultural Bankers Conference 21
22 Common Weaknesses or Issues Systems have too many subjective components Systems are too heavily weighted on assets or collateral based lending Moving Away from Typical Collateral (Balance Sheet) Lending By: Balance Risk Ratings by utilizing ROA and Solvency Ratios to offset the valuation approach the customer uses on the BS If collateral component: Utilize global collateral sensitivity analysis to get an idea of the shock or change to market value each asset class can withstand Goal - borrower s total debt with all lenders stays within an acceptable industry loan to value range despite a market downturn WBA Agricultural Bankers Conference 22
23 Implementing Risk Rating Takes Time If new to your staff and portfolio or If you dramatically upgrade your current system Remember Credit Risk Rating Systems quantify risk but are not THE answer The system is a tool for your experienced lenders Implementation Tips Field test or back test your metrics Look for anomalies Evaluate the result Introduce the system with 10-20% of the portfolio Buffer outliers current score vs. average score Isolate extremely high or low ratios WBA Agricultural Bankers Conference 23
24 Common Pitfalls to Avoid A system too focused on assets Reverting back to collateral based lending is tempting Allowing historic income (super cycle) levels to disguise management weaknesses or a highly leveraged position Weighing subjective criteria too heavily Allowing Management to override more objective measures of risk Great Ag Lenders Will Shift Customers to Accrual Financial Analysis Be Versed in Risk Management/Commodity Marketing Become More Education Oriented Have a Keen Understanding of Each Customer's Business Possess Above Average People Skills WBA Agricultural Bankers Conference 24
25 Warnings, Watches and Clear Blue Skies; Forecasting with Ratios and Risk Ratings Tim Ohlde, CEO Country Banker Systems Connect with me on LinkedIn and Twitter WBA Agricultural Bankers Conference 25
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