‘Sweet 16’ Financial Ratios Expanded, Now ‘Legal 21’

For more information, contact
Joe Daughhetee
(217) 431-2727
joeagcpa@yahoo.com

(March 30, 2010, Danville, IL)—Those 16 financial methods and formulas set up nearly 20 years ago as analysis techniques for measuring financial viability of farm and ranch operations have now grown into the "Legal 21," according to the Farm Financial Standards Council, which developed the original 16.

"The original formulas came about as the Farm Financial Standards Council met to develop uniformity and standardization in financial reporting for agricultural producers," says Phyllis Parks, CPA, president of the Council. "The Task Force, as it was called then, was a group from all over the industry that was organized to help agricultural producers get out from under the financial debacle that grew from the farm crisis of the 1980s," she explains. "The group initially met in 1989 and has evolved since that time. However, it is still composed of an eclectic group of ag lenders, accountants, academics, producers and consultants."

The major premise was that the financial information should be prepared on an accrual basis of accounting. This method results in more reliable and accurate financial measurement of a business. Under the accrual method, income is reported when actually earned vs. timing of only when collected. Expenses are reflected when actually incurred vs. timing of only when paid.

The accumulated financial data is reported on three different reports. The Balance Sheet is a snapshot of the financial picture of a business at a definite period of time (i.e., last day of fiscal year). The second part is the Income Statement which summarizes operational results for a given period of time (i.e., for fiscal year ending). The third presentation is the Cash Flow Statement which summarizes source and applications of cash during a given period of time (i.e., for fiscal year ending). These three statements are coordinated and related to each other for the period being reported.

The financial data from these statements are then used for the financial analysis, which is done in five major categories: Liquidity; Solvency; Profitability; Repayment Capacity, and; Financial Efficiency.

Parks notes that as the ‘Sweet 16’ received greater acceptance and use, it became apparent that there were five more analysis procedures which were beneficial to financial analysts. "As the Council adopted these new techniques, it felt it would be appropriate to refer to the new roster of methods and formulas as the ‘Legal 21.’

The additional techniques are:

• Working Capital to Gross Income (Liquidity)—Measures operating capital available against the size of the business.
• EBITDA (Profitability)—Earnings before interest, taxes, depreciation, and amortization—measurement shows the earnings of the business that are available for debt repayment.
• Capital Debt Repayment Capacity (Repayment Capacity)—Measurement of all sources of income that could be used to pay debt (both farm and non-farm sources of income.)
• Replacement Margin (Repayment Capacity)—Enables borrowers and lenders to evaluate the ability of the operation to generate funds necessary to repay debts with maturity dates longer than one year and to replace assets.
• Replacement Margin Coverage Ratio (Repayment Capacity)—To show if enough income was generated to cover term debt payments and the cash contribution for new equipment.

Parks explains that all 21 ratios and guidelines, along with formula details, are available in the Financial Guidelines for Agricultural Producers, a document prepared by the Council. It is available on CD format and can be ordered by visiting the Council website at www.ffsc.org.