Description of assets, liabilities, equity, and financial ratios

The Canadian farm balance sheet has been designed to: record the value of farm business assets; record the value of farm business liabilities; record the value of equity for farm businesses; display standard financial ratios which are based on estimates from the balance sheet and the value-added account; be based on the establishment concept; display the information at December 31, by province.

Four different balance sheet accounts have been developed in order to separate the assets and liabilities of farm businesses from those of farm operator households and non-operator landlords. Non-operator landlords are individuals or businesses not engaged in the activity of farming who lease assets to farm operators.

In this series, data are provided only for the Balance Sheet of the Agricultural Sector (set 2). This is because set 2 most closely reflects the assets employed in the production of agricultural products. The other sets of balance sheet accounts are available on request. The four sets of aggregate balance sheets produced for Canadian agriculture are as follows:

Set 1 - The Balance Sheet of the Agricultural Sector and Farm Operator Households includes all farm sector assets and liabilities regardless of ownership. It treats the farm operator households and farm businesses as a single entity. It also includes farm real estate assets leased from non-operator landlords and the liabilities outstanding on these assets.

Set 2 - The Balance Sheet of the Agricultural Sector is designed to account for only those farm assets and liabilities used in the production of agricultural products. This set includes farm real estate assets leased from non-operator landlords and the liabilities outstanding on these assets. It also includes automobiles, trucks and farm machinery leased to farm operators. It treats the farm operator households and farm businesses as separate entities, so the personal portion of farm households’ assets and liabilities is excluded.

Set 3 - The Balance Sheet of Farm Businesses and Farm Operator Households reflects the position of farm operators and includes the assets and liabilities of both farm businesses and farm operator households. Thus, the value of farm real estate leased to farm operators by non-operator landlords is not part of this balance sheet. Similarly, the liabilities related to these leased assets are excluded.

Set 4 - The Balance Sheet of Farm Businesses of Farm Operators includes only the farm business portion of assets and liabilities. This account excludes the assets and liabilities of both non-operator landlords and farm operator households.

The layout of the balance sheet follows that recommended in the Farm Accounting Standardization Manual, published by the Farm Accounting Standardization Review Committee, Farm Credit Corporation, 1991. Some definitions and comments on the concepts and ratios have also been extracted from this manual.

Although ratio analysis can assist in managing and analyzing a business, a proper financial analysis of the business requires more tools than just ratio analysis. Consequently, complete reliance upon such financial measures is a very unsound business practice. The four major types of financial ratios which have been calculated include: liquidity, solvency, profitability, and financial efficiency.

The ratios calculated in the tables reflect an aggregate ratio for the agricultural sector. Users should note that the desired and actual value of the ratios will vary significantly according to the type of farming activity (livestock, crop, horticulture, etc.).

When developing and interpreting financial ratios, many limitations must be kept in mind, such as the method of asset valuation; the type, size, and cycle of the business; and the information used to prepare them. Ratios are most meaningful when compared between years. For further information on developing and interpreting financial ratios, refer to the Farm Accounting Standardization Manual.

Users should be especially cautious in using estimates of accounts receivable and cash, bonds and savings data in the provinces of Manitoba, Saskatchewan, Alberta and British Columbia. The estimates of cash, bonds and savings in these provinces may include the value of deferred grain receipts whereas these receipts are generally reported under "accounts receivable". This should not affect the aggregate estimates of current assets.

Current assets are assets which in the normal course of operations are expected to be converted into cash or consumed in the production process within one year. The three components include: cash, bonds and savings; accounts receivable; and inventories.

Accounts receivable are amounts owed to farm businesses, usually arising from the sale of goods or services. Examples include uncollected receipts for grain or livestock sales, or custom work performed.

Inventories are items of tangible property which are held for sale in the ordinary course of business or are in the process of production for such sale, or are to be directly consumed in the production of goods or services. The three categories of inventories are: poultry and market livestock; crops; and inputs.

Poultry and market livestock include chickens, turkeys, slaughter beef heifers, steers, calves, pigs other than boars or sows, and market lambs.

Crops include wheat excluding durum, durum wheat, oats, barley, rye, corn, flaxseed, canola, soybeans, mustard seed, canary seed, sunflower seed, dry peas, chickpeas, lentils, tobacco, and potatoes.

Inputs include feed, seed, fertilizer, chemicals, fuel, and other supplies used for farm businesses.

Prior to 1991, household contents include assets such as furniture and appliances. The farm business portion of household contents refers to office fixtures, equipment and supplies.

Quota is essentially a license, or a right, to sell a certain amount of a specific commodity. This right is regulated by marketing boards. Some quotas (such as milk) are transferable and therefore have a value associated with them. In provinces where quotas are traded, quota values reflect current market values. In provinces where quota trading is prohibited, quota values are implicitly reflected in the value of fixed assets of agricultural holdings because some of the value of quota is normally capitalized into fixed assets.

Breeding livestock consists of animals acquired or raised for the production of progeny, or for the production of a livestock product. Breeding livestock includes bulls, dairy cows, beef cows, dairy heifers, beef replacement heifers, boars, sows, rams, ewes and replacement lambs. Also included are all animals on fur farms at December 31 because all or the great majority of these are breeding stock.

There are three components of machinery: autos, trucks, and other machinery. Other machinery includes equipment for tillage, planting, fertilizing, chemical application, harvesting and haying; dairy, poultry, and other livestock equipment; and other miscellaneous items. As of 1991, computers and other office equipment used for the farm business are included with other machinery.

Farm real estate includes land, service buildings and homes (owned and leased). The value of land includes all farmland operated by farm operators. The value of service buildings includes all buildings except homes. The value of homes includes all farm dwellings occupied by farm operators.

Other long-term assets include long-term investments, as well as AgriInvest balances (beginning in 2008). Prior to the end of the programs in 2007, and the subsequent closure of all the producer accounts in 2009, Net Income Stabilization Account (NISA) balances and, in Québec, balances in the “Compte de stabilisation du revenu agricole” (CSRA), were also included. This series starts in 1991.

Total assets include all tangible and intangible items of value at December 31. It is the sum of current assets, quota, breeding livestock, machinery, farm real estate and other long-term assets.

Current liabilities are payable within the current year. Examples include accounts and notes payable within the year.

Long-term liabilities have a maturity beyond one year from the date of the balance sheet. Examples include mortgages and equipment loans owed by farm operators to various lenders. These lenders include: chartered banks; Farm Credit Canada; the Business Development Bank of Canada; credit unions; treasury branches; federal and provincial agencies; insurance, trust and loan companies; supply companies and private individuals, Veterans Affairs and advance payment programs.

Total liabilities include all obligations of a business arising from past transactions that are to be paid in the future. Total liabilities are the sum of current and long-term liabilities.

Equity refers to the ownership interest in the business. Equity equals total assets minus total liabilities and could be considered to be the owners’ claim against the assets of the business. Equity is increased by the owners’ net contribution of assets to the business and the accumulated net income of the business. As equity is derived residually, by definition any change in the value of assets and liabilities will cause a proportionately larger change in the value of equity.

Liquidity refers to the ability of a business to meet financial obligations as they come due in the ordinary course of business. Three liquidity ratios are calculated using balance sheet values: the current ratio, the acid-test or quick ratio and the debt structure ratio.

The current ratio measures a business’ ability to meet financial obligations as they come due, without disrupting normal operations. If the current ratio is greater than 1, the business is considered to be liquid. A ratio of less than 1 may indicate a potential liquidity problem. Users should note that a favourable liquidity position may be a misleading indicator of the ability of current assets to cover current liabilities because a significant portion of the current assets may be comprised of inventories which may not be easily converted to cash. Also, the value of the ratio may vary depending upon the production cycle, (eg. the ratio may obtain a significantly different result if calculated in the fall when inventories are typically high than in spring when inventories are usually depleted). The ratio is also limited in that it does not predict the timing or the adequacy of future cash flows.

The acid-test (quick) ratio is a variation of the current ratio, and is defined as the ratio of cash, marketable securities, and accounts receivable to current liabilities. The exclusion of inventories in the calculation allows for an assessment of the "immediate" liquidity position of farm businesses. An acid-test ratio of 1 indicates that there are just enough assets of a very liquid nature to cover current liabilities. The desired value of the ratio varies according to type of farming activity. For example, the desired value of the ratio for a dairy operation will be different than for a grain operation. The ratio is also limited in that it does not predict the timing or the adequacy of future cash flows.

The debt structure ratio measures the proportion of current liabilities to total liabilities. This ratio, in conjunction with the current ratio, will provide information on the relative solvency of a business. A high debt structure ratio may indicate solvency problems. However, this may not always be the case, especially for farm businesses with a relatively low value of long-term liabilities. In this case, businesses may have no solvency problems. Thus, it is important to interpret this ratio in conjunction with the value of liabilities and cash flow from farming operations.

Solvency refers to the financial measures that gauge the amount of debt of a business relative to the amount of capital invested in the business. Three solvency ratios are calculated using values from the balance sheet: leverage, equity, and debt. These ratios are indicators of the risk involved in investing in the operation: the higher the debt, the greater the risk to all investors.

The leverage ratio is the value of total liabilities per dollar of equity. The ratio is a measure of the degree to which the creditors have financed the business as compared to the owners. The higher the ratio, the greater is the financing of the farm business by creditors. A leverage ratio of 0.5, for example, indicates that the farm operators have twice as much equity as debt. The higher the value of the leverage ratio, the greater the creditors have financed the farm businesses and thus the higher the risk. The desired value of the ratio will depend upon the income variability of farm businesses and other factors such as the risk associated with production, farm businesses with high income variability or business risk would desire a lower ratio.

The equity ratio is the value of equity per dollar of total assets. The ratio measures the proportion of total assets financed by the owners, as opposed to that financed by creditors. The higher the ratio the more resources are supplied by the owners.

The debt ratio is a measure of the extent of leverage being used by a business, or the proportion of total assets financed by debt. The higher the ratio, the higher is the financial risk.

Profitability refers to the extent to which a business is able to generate profit from the utilization of the business resources. Profitability ratios are calculated using values from the balance sheet and the value-added account because the two series are conceptually and methodologically related. The three calculated profitability ratios are: capital turnover, return on assets and return on equity.

The capital turnover ratio indicates the extent to which a business efficiently utilizes its assets to generate revenue. The higher the ratio the more efficiently assets are being used to generate revenue. The desired value of the capital turnover ratio will vary significantly by type of farming activity. Users should be aware that the ratio is a comparison of flows over stocks, that is, revenues cover an accounting period while total assets refer to a specific point in time. Therefore, the ratio may be misleading in the event that total assets fluctuate significantly in one direction (either up or down) in the accounting period.

The return on assets ratio is a measure of return on investment; it reflects earnings per dollar of both owned and borrowed capital. The higher the ratio, the greater is the return on assets.

The return on equity ratio provides a measure of the return to the owner on the owner’s investment in the business, as it reflects only the return per dollar of owned capital.

Because the value of unpaid family and operator labour is not estimated, the usefulness and the interpretation of return on assets and return on equity may be influenced. Comparisons of these ratios to other return on assets and return on equity ratios should not be made unless the method of calculating the ratios is the same. These ratios do not consider the unrealized capital gains that may be present in the value of assets such as farm land. The higher the value of return on equity, the greater is the return on investment. However, a high value for this ratio may signify a highly leveraged business. Therefore, interpretation of the significance of this ratio should be made in conjunction with other ratios.

The return on assets ratio and the return on equity ratio reflect the different balance sheets. In sets 1 and 2, which include non-operator landlords, the returns include rent to non-operator landlords. In sets 1 and 3, which include the personal share of households, the returns include the family wages.

Financial efficiency refers to the extent to which a business is able to efficiently utilize the businesses resources.

The interest coverage ratio is one of the most widely used financial efficiency ratios for analyzing the ability of a business to pay the interest on debt. Similar to the return on assets or equity ratios, the interest coverage ratio reflects the inclusion or exclusion of non-operator landlords and the personal share of households.