Financial Ratios Give Mixed Reviews  Despite Higher Co-op Revenues

David Chesnick
Agricultural Economist
USDA Rural Business Cooperative Service 

As reported in the first two articles of this series (see Sept./Oct. Rur~ al  Cooperatives), the combined operations of the  Top 100 agricultural cooperatives showed  record setting sales and growth in 1995.  However, not all is rosy on the financial front.  While some cooperatives had a stellar  performance, others found disappointment in  1995. This article looks at performance  measurements for the nation's 100 largest  agricultural cooperatives. Although the ratios  used in this analysis are the same as in prior  studies, they are calculated differently.  Therefore, revised 10  year trends are  provided.

    In past studies, the ratios were calculated  using the sum values of all Top 100  cooperatives. Therefore, larger cooperatives  had more weight on the calculated ratio values  due to their sheer size and business volume. In  this study, ratios for each cooperative are  calculated and the average of these 100 ratios  is then used. This way, all cooperatives in the  Top 100 are weighted equally.

    This report will examine four types of performance measurements:

• Liquidity, which shows the cooperative's capacity to meet short run obligations.
• Leverage, which shows the cooperative's capacity to meet its long term and short term debt obligations.
• Activity, which shows how effectively the cooperative is using its assets.
• Profitability, which shows the net  returns on sales, assets, and equity.

    Liquidity ratios measure a firm's ability to fulfill short term commitments from liquid assets. These ratios are of particular interest to the company's short term creditors. Liquid assets include cash, marketable securities, accounts receivable, inventories and other debts owed to the cooperative with near maturity dates. These  assets can be converted to cash quickly to  meet maturing short/term obligations. The  current and quick ratios are the two most  commonly used measures of liquidity.

    The current ratio is calculated by dividing  current assets by current liabilities. The  growth in current assets was slightly less than  current liabilities in 1995, culminating in a  slight drop in the current ratio. The average  current ratio declined from 1.38 to 1.37 (figure  1). Even though the drop was minimal, it is at  a 10 year low. Lenders may be concerned if  this trend continues.

    Most of the growth in current assets during  1995 was due to inventory buildup. This is  evident in the sharp drop in the quick ratio  relative to the current ratio. The quick ratio  does not consider inventory in the calculation  and is subtracted before dividing by current  liabilities. The quick ratio also reached its  lowest point in 10 years. It is down from 0.80 to 0.76 between 1994 and 1995, a troubling trend.

    However, omitting inventories from the quick ratio is based on the belief that they are the least liquid component of the current assets group. While this is generally true for most businesses, the inventory for some marketing cooperatives may be more liquid than some slow  paying receivables. Table 1 shows all the 1995 ratios by commodity group. Grain, rice, sugar and fruit & vegetable cooperatives have the lowest quick ratios. Generally, inventories average more than one half of their total current assets value. The inventory in these marketing cooperatives are liquid in financial terms, so the low values for the quick ratio should not be too alarming.

Leverage

    The leverage ratios examine the capital structure of a business and its ability to handle both short  and long term debt. The significance of capital structure is derived, primarily, from the essential difference between debt and equity.

    Equity is the basic risk capital of a cooperative. Although most cooperatives return member equity according to a designated plan, it can be counted on to remain invested in times of adversity. By contrast, debt must be repaid despite the cooperative's financial condition. Members may lose control of their cooperative if it fails to cover the debt payments.

    Three commonly used ratios for analyzing leverage are debt to assets, long term debt to equity and times interest earned. These ratios should be of interest to both creditors and members.

    The debt to asset ratio is calculated by dividing total debt by total assets. This shows how much of the cooperative's assets are claimed by creditors. In 1995, the Top 100 averaged a debt to asset ratio of 0.63 —the highest value in the past 10 years. This is up slightly from 1994. However, as figure 2 shows, the Top 100 cooperatives have since 1986 financed, on average, between 60 and 63 percent of their assets with debt. Cotton cooperatives average the lowest ratio at 0.53 percent and poultry and livestock cooperatives had the highest ratio, 0.85 percent.

    Where short term debt is generally used to finance current operations, long term debt finances long term assets. Member equity is also considered long term capital. The long term debt to equity ratio shows the relationship between debt and equity financing of long term assets. Figure 3 illustrates the trend for the past 10 years. After a steady drop throughout the late 1980s and early l990s, the trend is beginning to reverse. During the past 2 years, the Top 100 cooperatives have
increasingly relied on debt. Their long term debt to equity in 1995 was at 0.47, up from 0.43 in 1994. This shifting of capital structure toward more debt financing should be carefully watched in the future.

    The last leverage ratio is mainly concerned with covering interest payments. Times interest earned (TIE) is calculated by dividing earnings before interest and taxes by interest payments. Creditors want to know if the cooperative's operations generate enough margins to cover the interest payments. The regular interest payment is a hurdle that cooperatives must keep jumping to avoid default. This ratio measures by how much the cooperative clears that hurdle. However, this measure only tells part of the story. It does not include other fixed charges, such as principal and lease payments.

    The average TIE ratio has remained relatively flat during the past 4 years at a little more than six times (figure 4). Dairy cooperatives had the highest TIE average in 1995 at 11.8 times. Fruit and vegetable (2.1 times), poultry and livestock (2.1 times), rice (1.7 times) and sugar (1.1 times) all had below average TIE ratios. While most cooperatives had a sufficient coverage ratio, nine cooperatives had trouble covering their interest payments.

Activity Ratios

    Activity ratios show how well a business uses its assets in generating sales. The two ratios used in this study are total asset turnover and fixed asset turnover. These ratios imply that each dollar invested in assets will generate so many times more in sales. While this provides insight into productivity, the components that make up the ratios should be examined in more detail. For example, a business with old, fully depreciated facilities could have a high ratio. Another business with excess capacity because it recently expanded would have a low ratio. Therefore, these ratios are a starting point in the analysis.

    The total asset turnover relates total assets to sales. The higher the value, the more efficient the assets are being used. The average cooperative's total asset turnover was 3.27 in 1995, down from 3.48 in 1994. This decrease contrasts with the relatively stable value during the past 6 years (figure 5). Most of this decline related to a higher growth rate in current assets or, more specifically, inventory.

    The average fixed asset turnover ratio also declined in 1995 (figure 6) due largely to the smaller cooperatives in the Top 100. They averaged a slight increase in their fixed assets base while sales were down from 1994, thereby producing lower turnover ratios. The larger cooperatives, on the other hand, had proportional increases in both fixed assets and sales revenue. The net effect was a drop in the fixed asset turnover.

Profitability Ratios

    Profitability ratios measure the power of the cooperative's earnings. With poor earnings, the cooperative may soon find that it cannot meet its obligations and be forced out of business. However, measuring profitability for cooperatives is not as easy as with other forms of businesses. First of all, the nature of a cooperative is to fill a market need of its members. Cooperatives typically have lower returns than investor owned firms because they emphasize maximum payments to members and minimize costs for supplies.

    The excess of sales above the cost of sales is commonly referred to as gross margins. This represents the pricing policy of the cooperative, along with how much revenue is left to cover both operating and non operating expenses. Figure 7 shows the Top 100 agricultural cooperatives' gross profit margins as a percent of total sales revenue for the past 10 years. Gross profit margin reached 15 percent in 1995 for the first time since 1988. Much of this improvement can be attributed to the rice, cotton and fruit & vegetable cooperatives.

    The net operating margins illustrate how much net margins before interest and taxes are generated by a cooperative's operations. This ratio only looks at the return on operations and excludes nonoperating income and expenses such as interest income, patronage refunds received and gain/loss from discontinued operations.

    Even though the sum of net operating margins for all cooperatives is higher in 1995 than in the past 10 years, the average net operating margins as a percent of total revenue is down. Figure 8 presents the average ratio of net operating margin to total revenue during the past 10 years. This implies that the operating expenses for some cooperatives are increasing faster than their operating revenues. Those cooperatives need to keep an eye on their expenses before they begin to eat into their margins.

    As mentioned in an earlier article, cooperatives invest in assets for future benefits. To provide a measurement for the return on these investments, return on total assets is commonly used. This return is calculated by dividing net margins before interest and taxes by the average total assets. The reason net income before interest and taxes is used is because total return is measured by looking at the return to all investors, including equity holders, debt holders and even government claims (taxes). Taxes are also included because the board of directors has some control over the amount of taxes they pay. It is best to use an average asset value for  measurement because revenues are measured  throughout the year. The amount of assets  varies from period to period within the year.  However, without the additional data needed  to average, the year end value will suffice.

    The return on total assets improved to 7.75  percent, continuing to rebound from a 10 year  low of 6.67 percent in 1993 (figure 9). Much  of the increase was caused by an increase in  non operating revenue. Nearly two thirds of  the Top 100 cooperatives had higher  non operating revenue in 1995 than in 1994.  Cotton and farm supply cooperatives had exceptional returns on their assets.  Pooling cooperatives had the lowest returns.  However, these have more to do with higher  member payments for their products, hence  lower margins.

    After deducting interest payments and  taxes, return on member equity was down  from 14 percent in 1994 to 13 percent in 1995  (figure 10). Higher interest payments and taxes  contributed to this decline. While dairy, fruit &  vegetable and poultry & livestock cooperatives  took the hardest hit, grain and cotton  cooperatives seemed to thrive in the economic  environment of 1995.
 
    To summarize: with higher sales and lower  cost of goods sold, there were, on average,  more gross margins available to the Top 100  cooperatives. To obtain these higher gross  margins, the cooperatives had to increase  operating expenses. This is shown by the Top  100 cooperatives having a smaller  proportional increase in operating margins.  However, revenues from nonoperating sources  more than made up for the increases in  operating expenses, thereby showing a higher  return on total assets. Yet, due to higher  amounts of debt and taxes, the total return to  members equity was down slightly from 1994.