University of Wisconsin Center for Wisconsin
Rural Cooperatives, January/February 1996, pg. 22-26
Published by the Rural Business and Cooperative Development Service
On Solid Ground
Financial Ratios Show Cooperatives Gain Stability & Ability To Serve
Ratio analysis can be an important tool for management to use when formulating a cooperative's business plan. For example, if ratio analysis indicates that average inventory levels are declining for farm supply cooperatives nationally but your cooperative's inventory levels are increasing, there is cause for concern. Management will need to look closer at inventory control. The increase in inventory may simply reflect greater demand for certain products, which means inventory levels will have to increase to satisfy demand. On the other hand, inventory levels could be increasing because sales did not meet expectations. In this case, management may need to re-examine marketing policy.
Financial ratios are computed from an organization's income statement and balance sheet. Financial ratios are meaningful only when compared to cooperative industry averages over a set time period. Computing financial ratios is similar to taking a snapshot because the ratios reflect the fiscal status of a cooperative at just one point in time. Comparing ratios to industry averages is essential for uncovering positive and negative trends affecting your cooperative business. Trend analysis is an excellent way to identify a cooperative's strengths and weaknesses.
This report examines some key financial ratios, based on a 1994 survey conducted by USDA Cooperative Services of 603 agricultural cooperatives. It provides a broader look at many of the same ratios examined for the TOP 100 cooperatives in the November issue of "Farmer Cooperatives," with the emphasis on smaller cooperatives (see table 2 for a breakdown, by size, of the cooperatives included in this analysis). The objective is to provide local cooperatives with a basis to compare their operations to industry averages. The ratios examined below include growth, liquidity, leverage, activity and profitability.
Overall, this analysis shows that cooperatives appear to be positioning themselves quite well for the future. The tough times in the late 1980s forced many cooperatives to either go out of business or merge with other cooperatives. Cooperatives that survived are in better financial condition today to serve their members. However, this is no time to relax. Competition will force cooperatives to manage their assets and liabilities better and to continue to streamline their operations for a more efficient cooperative.
Table 1 - A summary of key financial ratios
Table 1 briefly describes what each ratio is and how it is calculated. Local cooperatives should consider plotting their own values against these industry averages for insight into the fiscal strength of their own organization.
To further help managers and board members compare key ratios with similar ratios, cooperatives are grouped into different sizes and types. The four sizes are based on sales volume. Financial data are actual; no attempt was made to deflate values. Table 2 lists the classification for size. To account for differences in operations and orientation based on product mix, cooperatives are also grouped into one of four descriptive categories for cooperative type. Table 3 presents the various categories for cooperative type. These descriptions are chosen to represent business operations of these cooperatives as closely as possible. Tables 4 through 7 present ratios for each type by size for 1994.
Table 2 - Cooperative size classification
Table 3 - Cooperative type classification
· Sales—Farm supply sales in 1994 were the highest in 10 years, on average, for cooperatives within this study. Average supply sales topped $5 million for the first time, an increase of over 5 percent from the prior year. Marketing sales, on the other hand, were down nearly 15 percent from 1993. Service income was also off 20 percent from the prior year. The cumulative effect of these changes are illustrated in figure 1. The average total sales and services for cooperatives were down nearly $750,000 from 1993, an annual percentage decline of 6.4 percent.
· Net Income—The drop in sales, however, was not all bad news. Net income average also reached a 10-year high. Interest income, patronage refunds and other income all showed an increase over prior years. Cooperatives also trimmed 1.4 percent off of their expenses. All these changes resulted in a 1 percent increase in net income to $231,446.
· Assets: Figure 2 shows the tremendous increases in assets in the early 1990s. With inventories nearly doubling and fixed assets increasing by over two-thirds, the average amount of total assets increased by just under 75 percent from 1990 to 1994. However, in 1994 total assets declined by about 4.25 percent. This decline was attributed almost entirely to a decline in inventories, especially grain inventories. While farm supplies remained unchanged from the prior year, grain inventories dropped 27 percent.
· Current ratio—Since 1990, the current ratio has been trending downward. In 1994, this trend reversed itself (figure 3). Despite the decrease in current assets, the current ratio increased slightly from 1993 to 1994. Current liabilities had a higher percentage decrease then the current assets. The drop in current assets was due to lower grain inventories. This decline in grain inventory also pushed down the grain accounts payable. However, this was not the only current liability to decrease. Cooperatives also transferred some of their debt from short-term to long-term, thereby causing a higher decrease in current liabilities vs. current assets. All other current assets and liabilities remained relatively stable. Cooperatives need to strive to maintain current ratio above 1.
· Quick ratio—Although not as apparent, figure 3 also shows that the quick ratio increased faster than the current ratio. All other current assets included in this ratio remained relatively stable. Declining short-term debt and accounts payable for grain cooperatives caused current liabilities to decline 13 percent. Therefore, the quick ratio showed a relatively substantial increase between 1993 and 1994. While this ratio is low (i.e., less than 1), there is no real rule of thumb to follow. However, some inventories, such as grain, can be more liquid than some accounts receivable. Therefore, cooperatives should strive to manage their current position so that they and their creditors feel comfortable.
Table 4 - Financial ratios for marketing by cooperative size, 1994
Table 5 - Financial ratios for mixed marketing by cooperative size, 1994
Table 6 - Financial ratios for mixed farm supply by cooperative size, 1994
Table 7 - Financial ratios for farm supply by cooperative size, 1994
· Total debt-to-assets ratio—The average amount of total debt outstanding for cooperatives fell slightly from 1993 to 1994. However, average total assets declined at a faster rate throughout the same period. As mentioned earlier, lower grain inventories were the main cause for the drop in assets. The result is a small decline in the total-debt to total-asset ratio. Cooperatives should strive to maintain a ratio similar to the average illustrated in figure 4 (between .2 and .4). A high ratio will indicate high amounts of debt and a bad year could mean trouble for the cooperative if it fails to meet its interest obligations. A low ratio is safe, but the members are financing most of the cooperative's operations and may be able to improve their return with a little more debt. Nevertheless, each cooperative must access their own needs and situation and determine where they want to be.
· Long-term debt-to-equity ratio— Throughout the 1980s, cooperatives were changing the long-term structure of financing. Since that time, there has been little change in their long-term capital structure. Figure 5 illustrates this point as cooperatives began using more equity to finance operations. This resulted in a dramatic decline in this ratio until 1990, at which time the ratio of long-term debt to equity has slowly inched upwards. Again, cooperatives need to examine their own situation. If the cost of borrowing capital is high, cooperatives may find it advantageous to rely more on member equity than debt to finance operations. Using more debt when interest rates are low could increase return on members' investment. It is interesting to note that the average amount of fixed assets increased dramatically from 1990 to 1992. Yet, during this period, the capital structure did not change much.
· Times-interest-earned ratio—Cooperatives should try to obtain a high times interest-earned (TIE) ratio. Higher interest expense in 1994 lowered the ratio from the 10-year high in 1993. However, figure 6 shows that the average ratio was still slightly above 4:1. A ratio substantially greater than 1:1 indicates cooperative have a strong ability to pay the interest on their debt. A lending institution will be more willing to work with a cooperative in this situation and might even charge lower interest. A ratio of less than 1 means the cooperative will have problems paying off its interest expense and might have to start reducing its equity accounts to cover the interest charges. Cooperatives with a low TIE ratio might have problems acquiring additional borrowed funds.
· Fixed asset turnover—Many factors can affect the fixed asset turnover (FAT) ratio. For example, the fixed assets (property, plant and equipment) could be old and close to fully depreciated, which could inflate the FAT ratio. Even though the ratio is high, maintenance costs to keep the equipment running could be excessive, lowering the overall performance of the cooperative. On the other hand, if the cooperative determines that a larger production capacity is needed in the future, it could immediately begin building excess capacity. Generally, fixed assets do not increase gradually over time; rather, they increase in "big chunks." The excess capacity from, for example, plant expansion will temporarily deflate the ratio until the plant reaches full utilization. Therefore, care must be taken when looking at changes in the value of the ratio. For the average cooperative, the ratio value has been near 9:1 since 1988. Figure 7 shows both the fixed and total asset turnover ratios.
· Gross Profit Margins—Gross profit margins in 1994 continued the upward trend that began in 1989. Perhaps the greatest influence on the average gross profit margin is the amount of farm supplies sold in relation to members products marketed. Farm supplies yield higher margins than do marketing sales of farm crops. The average farm supply margins in 1994 was 17 percent compared to 4 percent for crop and livestock marketing. Not only is there a marked variance between marketing and farm supply margins, there is also variance among the farm supplies within each product category. Cooperative managers should keep detailed records for each type of product and evaluate the changes from year to year.
· Return on total assets—The return on total assets (ROTA) provides the cooperative with another measure on how efficiently a cooperatives uses its assets. However, this ratio looks at the whole operation, not just sales. Net income before interest and taxes is used to calculate ROTA because the goal is to reveal total return on assets. Interest is a return to lenders while taxes can be thought of as return to government investment. Figure 9 illustrates the historical movement of ROTA over the past few years. The average net income generated from use of the cooperatives assets in 1994 was 7.2 percent. This continues an upward trend following a near 10-year low of 6.5 percent in 1992. However, it is not as high as it was in the late 1980s, when it averaged well over 8 percent.
· Return on allocated equity—Since this ratio looks at returns on member investment only, it is determined by calculating net income after interest and taxes. As is evident in figure 9, this ratio tends to fluctuate widely. When net income is high, cooperatives generally revolve equity back to members. This pushes the value up, as happened in the late 1980s. Low returns pull down the ratio. Between 1993 and 1994, the return on allocated equity remained steady. Returns that are too low might restrict the cooperatives cash flow.
Although there is a tremendous amount of variance among cooperatives, most are showing financial strength to carry them into the 21st Century. Cooperatives need to keep track of their performance in relation to the industry. Thus, when there is a change in performance, managers and board members will be able to take corrective action to enhance the performance of the business and ensure its long-term viability.