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September 12, 2018

Use Your Balance Sheet For Early Warning Signs of Trouble

Top Story  |   |  By: Jim Dickrell

If you can’t pay your bills on times, it’s a sure sign that your business may be in trouble. But regularly analyzing your balance sheet will give you a heads-up much sooner that your business could be heading toward rough water.

 

Dave Kohl, professor emeritus of ag economics at Virginia Tech University, looks at three different spots on the balance sheet for early-warning signs of trouble.

 

“One of the first ratios I look at is operating expense/revenue ratio, excluding interest and depreciation,” he says. This shows how much it costs your business to generate a dollar’s worth of income. In good years, top farmers will produce a dollar’s worth of revenue for less than 65¢. “Even those top producers today are finance costing 75¢ to 78¢ to generate a dollar’s worth of income, and for our bottom third producers, oftentimes it’s 95¢ to a dollar,” Kohl says. “Closely monitoring this ratio and the trend in this ratio is very critical.”

 

The next thing Kohl looks at is working capital and whether it is increasing or decreasing. “I like to divide working capital into expenses,” he says. “Once it’s above 33%, you’re pretty strong. But once that ratio starts getting less than 10% of your expenses, you’re going to have to be very careful that you don’t burn through your secondary reserve.”

 

The third area is term debt divided into EBITAD (earnings before interest, taxes and depreciation). “When this ratio is under 3:1, you’re in a pretty solid situation,” says Kohl. “When it starts getting above 6:1, you’re getting into a heavy debt situation in your ability to repay that debt.”

 

There are other areas to monitor as well that aren’t on the balance sheet, he says.

 

Are you building up accounts payable?

 

Are you seeing an increase in personal credit card debt?

 

Are your getting behind on your capital replacement strategy for equipment? The dairy industry is now four years into the downturn, and many farmers have postponed replacing equipment, he says. There will soon come a point when that equipment will have to be replaced. If the ratios above are weak, replacing that equipment could prove difficult.

 

To watch a video hosted by Compeer Financial of Dave Kohl further explaining his approach to balance sheet diagnostics, click here.

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