Leveraging the Future?
Higher Debt Levels Among Large Ag Co-ops May Be Cause for Concern

David S. Chesnick
Agricultural Economist
USDA Rural Business-Cooperative Service 

    A Latin proverb states: "No gain is as certain as is that which proceeds from the economical use of what you already have." In other words, the use of a cooperative's resources in an efficient manner should produce a healthy return to members.

    This raises an interesting question. How do you determine whether a cooperative is using its financial resources efficiently? The first two articles of this series examined the combined income statement and balance sheet of the nation's largest agricultural cooperatives. This third and final article in the series will try to interpret this data to determine how well cooperatives are using their resources.

    The nation's 100 largest agricultural cooperatives have experienced phenomenal growth in sales and assets during the past few years. However, a few cooperatives accounted for most of the gain. The big question that needs to be examined is: are cooperatives putting themselves in a position where a downturn in the economy can cause tremendous damage?

    As expressed throughout this series of articles, cooperatives are accumulating a record amount of debt to fund their expansion. As cooperatives become more leveraged, slight changes in revenue can have a tremendous effect on whether or not a cooperative has patronage refunds to return to members at year end. Increased sales help the cooperatives maintain a liquid position. However, higher expenses, especially for labor, continue to eat into the bottom line, as illustrated in the slumping profitability ratios, examined below. While some cooperatives are positioning themselves for the 21st century, others may find the next century will not be so favorable.

How USDA Evaluates Co-op Performance
The tools USDA uses to analyze cooperative financial performance include four types of primary measurements:

• Liquidity, which shows the cooperative's ability to meet short-run obligations.
• Leverage, which shows the risk associated with financing and the cooperatives' ability to meet its long-term and short-term obligations.
• Activity, which shows the efficiency with which the cooperative uses its assets.
• Profitability, which shows the net return on the cooperative's operations.

    The most common liquidity ratios used today are the current and quick ratios. Both evaluate the cooperative's short-term liquidity, measured by the degree to which it can meet its short-term obligations. Liquidity implies the ability to convert assets into cash in the current period. Liquid assets include cash, marketable securities, accounts receivable, inventories and other debt that is to be paid to the cooperative within the current fiscal year. Creditors who have a short-term interest in the cooperative will want to know if it can satisfy its commitment in case the cooperative has a cash-flow problem. Figure 1 illustrates both current and quick ratios from 1992 to 1996.

    The current ratio is calculated by dividing total current assets by total current liabilities. As figure 1 shows, the liquidity of the largest agricultural cooperatives has slowly eroded since 1993. The major cause of this decline was the increased reliance on short-term debt over the past few years. Cash balances were also down 6.5 percent in 1996.

    Table 1 lists the ratios by commodity type for 1996. The liquidity trend in cotton, dairy, grain, poultry/livestock and rice cooperatives is declining. On the other hand, diversified cooperatives strengthened their liquid position, but were unable to pull up the overall average. The rest of the commodity groups remained steady over the past five years. Except for grain and poultry/livestock cooperatives, the largest agricultural cooperatives are still maintaining a current ratio well above 1. Poultry/livestock cooperatives were the least liquid, with current liabilities greater than current assets.

Table 1-Ratios by commodity type for 1996

	Current Ration	Quick Ration	Debt to Assets	Long-term Debt to Equity	Times Interest Earned	Total Assets Turnover	Fixed Assets Turnover	Gross Profit Margin	Net Operating Margin	Return On Total Assets BIE	Return On Members Equity
	------Ratio------				------Times------			------Percent------
Cotton	1.78	1.22	49.37	0.27	6.50	5.11	24.45	17.24	6.05	18.30	19.22
Dairy	1.26	0.90	62.51	0.33	9.03	5.47	25.15	7.85	1.31	7.63	18.41
Diversified	1.85	1.15	66.34	1.33	4.48	2.52	11.49	11.54	1.11	8.48	14.40
Fruit/Vegatable	1.37	0.63	67.61	0.70	1.84	2.19	12.15	22.66	0.29	3.56	3.01
Farm Supply	1.52	0.78	55.37	0.38	7.49	2.69	12.70	15.18	3.85	9.41	12.98
Grain	1.08	0.52	65.58	0.28	1.95	3.72	13.82	7.72	-0.54	6.47	8.72
Poultry/Livestock	0.97	0.96	81.23	0.96	2.95	7.43	66.65	2.28	-1.24	3.84	4.65
Rice	1.32	0.51	58.94	0.30	1.51	2.28	6.36	30.16	0.56	5.14	2.10
Sugar	1.33	0.65	57.56	0.84	2.41	1.33	2.24	22.80	0.43	2.95	1.51

    The quick ratio is calculated the same way as the current ratio, but inventories are excluded from the current assets. Many analysts believe that inventories cannot be converted to cash as quickly as the other current assets during liquidation. Also, if the inventory needs to be liquidated, the cash value will in all likelihood be much less than the book value. Therefore, it can be argued that the quick ratio is a better measure of liquidity.

    Despite the drop in the current ratio, the quick ratio increased slightly in 1996. Cooperatives did not have as large of an inventory buildup as they had in 1995. This is evident by the way the current ratio  dropped while the quick ratio increased.  Cotton, dairy and rice cooperatives were the  exception. Cooperatives in all three of these  commodity groups had larger increases in their  inventory in relation to other current assets,  thereby lowering their quick ratio.

    The poultry/livestock commodity group  shows some interesting trends. While  generating the lowest current ratio, this  commodity group has one of the highest quick  ratios. Poultry/livestock cooperatives do not  carry much inventory. Less than 2 percent of  their total current assets include inventory,  while the average for all the largest  cooperatives is more than 45 percent.

Leverage

    If assets are the building blocks for a  cooperative's future, the capital structure is  the cement that holds it together. Equity is the  basic risk capital put up by members of the  cooperative. There must be some equity  within the capital structure to help a co-op  bear the risk associated with doing business.  Debt is the use of someone else's capital for a  fixed cost. Thus, if the fixed cost of the debt is  lower than the returns those funds generate,  the excess returns will accrue to the members.  On the other hand, if the revenues are less
than the fixed cost of the debt, member equity  takes will have to absorb the loss. This is the  concept of leverage.

    The first leverage ratio, debt-to-asset, is  calculated by dividing total liabilities by total  assets. This represents assets claimed by  outside interests. Figure 2 shows how this  ratio has been moving during the past five  years. Except for 1994, creditors are laying  claim to more assets each year. However, two  commodity groups (farm supply and cotton)  are bucking this trend and are using a higher  percent of equity to finance cooperative  operations in 1996. Of these two groups, only  cotton cooperatives had a ratio of less than  one-half. On the other hand, poultry/livestock  members owned less than 20 percent of their  cooperatives' assets. The other commodity  groups all had slight increases in the ratio of  total debt to assets and did not deviate much  from the total average.

    The second leverage ratio is long-term  debt-to-equity. Since both equity and  long-term debt take a long-run view of  financing, they provide a useful comparison.  After showing substantial declines throughout  the 1980s, this trend reversed in 1994. Since  1994, the priority of debt financing has taken  on a more prominent role for the top  agricultural cooperatives. Figure 3 illustrates  this point. In 1994, the value stood at 0.42, by 1996 long-term  debt-to-equity reached 0.48.

    The biggest users of long-term debt  continue to be the diversified cooperatives.  These co-ops held $1.7 billion of long-term  debt and were the only group of cooperatives  with a ratio of more than 1. Their long-term  debt to equity ratio was 1.33. Sugar and  poultry/livestock cooperatives also have  experienced tremendous increases in the  amount of long-term debt incurred compared  with member equity. The ratio for sugar  cooperative jumped from 0.56 in 1995 to 0.84  in 1996 while the poultry/livestock  cooperatives jumped from 0.77 to 0.96.

    The last leverage ratio is times interest  earned (TIE). This ratio is primarily used to  look at interest payments and determine  whether the cooperative has enough net  income to cover those payments. It is  calculated by dividing earnings (before interest  and taxes) by interest payments. A note of  caution is needed here. This ratio looks at the  minimum payments needed. It does not  include other fixed payments such as principle  and lease payments.

    As expected with the surge in debt  accumulation, the average TIE dropped from  6.5 in 1995 to 4.9 in 1996 (figure 4). Pushing  this decline were dairy, fruit/vegetable and  grain cooperatives. However, dairy co-ops still maintain the highest average  TIE of all commodity groups. Despite the  large increase in the debt of diversified  cooperatives, their TIE ratio continues to  improve. Another surprise is the trend for  poultry/livestock cooperatives. With all the  accumulation of debt over the past few years,  their TIE (while still below average) showed  substantial improvement. Less positive, 10  cooperatives did not have enough income to  cover their interest expense. This is up from  six co-ops in 1995.

Activity

    Where the first two types of ratios  examined the capital structure and the  cooperative's ability to meet its fixed obligations, the next two look at the operating  performances. Activity ratios reveal how  much revenue is generated by each dollar  invested in the cooperatives assets. The higher  the ratio the more efficient the assets are used.

    The first activity ratio, local asset turnover, is calculated by dividing total  revenues by local assets. Local assets are total  assets less investments in other cooperatives.

    The average local asset turnover for the  largest agricultural cooperatives hit a five year  high of 3.83 (figure 5) in 1996. This dramatic  increase was caused by both higher record  revenues and a higher proportion of assets  held as investments in cooperatives. In 1995,  investments in other cooperatives represented  6.75 percent of total assets. By 1996, that  number stood at 7.45 percent. Compared to  other commodity groups, dairy, cotton and  poultryAivestock cooperatives average less  assets, which helps explain their high turnover  ratios.

    The second activity ratio, fixed asset  turnover, looks at how efficiently the  cooperative uses its fixed assets. It must be  noted that this ratio could be misleading. A  cooperative with fully depreciated assets  could have a high ratio due to the low book value of its fixed assets. On the other hand, a  cooperative that is expanding its operations  could have a temporarily depressed ratio  because the new capacity is not fully used at  this time. Therefore, other information—such  as the average age left on the fixed assets and  how much new equipment is purchased—will  be needed to help interpret the fixed asset  turnover ratio.

    Cooperatives are purchasing fixed assets at  a record rate. In 1996, cooperatives purchased  $1.5 billion of fixed assets, the highest amount  since USDA began tracking it. Net fixed assets  also hit a new high of $7.6 billion during the  same period. The average age left on fixed  assets is calculated by dividing their net fixed  assets by current depreciation expense. The  average age left for fixed assets owned by the  largest 100 cooperatives is 8.81 years, the  longest it has been in 10 years. This further  indicates cooperatives are purchasing new equipment to replace their old,  worn-out fixed assets at a record pace.

    With this in mind, we turn our  attention to figure 6, which illustrates the  fixed asset turnover ratio for the past five  years. This ratio is up from 17.8 in 1995 to  18.1 in 1996. Cooperatives are expanding  their operations and their fixed asset  turnover ratio is also increasing. This  would imply that the average cooperative  is using its assets more efficiently to  generate higher sales. However, not all  commodity groups reaped the benefits of  their fixed asset investments. Only four  out of nine commodity groups showed  higher efficiencies. These include dairy,  diversified, fruit/vegetable and grain.

    Cotton, rice, and poultry/livestock  cooperatives averaged less revenue in  1996 than in 1995. This, coupled with  greater investments in fixed assets,  depressed their turnover ratios. Sugar  cooperatives did not produce enough  revenue to cover their investments so  they experienced a significant drop in their fixed asset ratio.  Revenue for farm supply cooperatives  was greater than investment, but one  cooperative had such a dramatic drop in  its ratio that is depressed the overall  average turnover ratio for that commodity  group.

Profitability

    Because cooperatives often have other  objectives in addition to generating  returns for their members, their  profitability ratios may be lower than for  investor-owned firms. However,  comparisons for a single cooperative or  group of cooperatives over time can be  very informative. The four profitability  ratios used in this report include gross  margin percent, net operating margins,  return on total assets and return on  member equity.

    Gross margins are the excess of  revenues above the cost of goods sold.  All operating and non-operating expenses  plus payment of patronage refunds,  dividends and income taxes must be  covered by the gross margins. Gross margins also  indicate the pricing policy of the  cooperative. In other words, is the  cooperative charging enough for the  products sold or paying too much for  member products to cover its expenses.

    Figure 7 illustrates the five-year trend  for average gross margin as a percent of  total revenue for the nation's 100 largest  agricultural cooperatives. Although gross  margins have increased during this time,  gross margins as a percent of total  revenues have dropped. However, not all  is gloom and doom. Cotton and sugar  cooperatives reversed their downward  trend and posted an increase in gross  margins. Cotton cooperatives increased  their gross margin percent from 15.4  percent in 1995 to 17.2 percent in 1996  while sugar cooperatives moved from 20.7  to 22.8 percent during the same time.

    The largest decline in gross margin  percents occurred in the dairy, grain and  fruit/vegetable cooperatives. These three  commodity groups were the main reason  for the decline in the average ratio—most  likely due to higher prices paid to  member-producers. Grain cooperatives  suffered the largest drop, declining from  10.8 percent to 7.7 percent between 1995  and 1996. Dairy and fruit/vegetable  cooperatives dropped from 8.4 to 7.8  percent and 23.9 to 22.6 percent,  respectively.

    Net operating margins look at the  profitability of cooperative operations. It  is calculated by taking the gross margin  and subtracting operating expenses and  interest, then dividing by total revenue.  Nonoperating items (patronage refunds,  interest income, gains/losses on the sale  of assets, and any other extraordinary  revenues or expenses not directly related  to operations) are not included in the  calculation.

    Figure 8 shows that after hitting a  record high of 1.7 percent in 1995, net  operating margins slipped to 1.2 percent,  near the pre-1994 average. Lower margins  and higher operating expenses squeezed operating margins in 1996. The number of cooperatives with operating losses dropped substantially, from 23 co-ops in 1992 to 13 co-ops in 1993. Throughout the next three years, the number of cooperatives operating with a loss climbed steadily, reaching 21 in 1996. Most of the cooperatives with operating losses were in the sugar, grain and poultry/livestock commodity groups. Although the sugar and poultry/livestock groups still posted operating losses, their 1996 losses were smaller than in 1995. The higher prices paid to members of the grain commodity group pushed their operating losses higher.

    Cotton cooperatives had the highest net operating margins,6.1 percent, a dramatic improvement from 4.4 percent in 1995. Farm supply cooperatives also had high net operating margins. However, they dropped from 4.5 percent in 1995 to 3.9 percent in 1996.

    Return on total assets is calculated by taking net income before taxes and interest divided by total assets. This ratio looks at the overall return on total assets. After inching up throughout most of the l990s, the return on total assets took a downward turn in 1996.

    The two commodity groups that contributed most to this decline were grain and fruit/vegetable co-ops. These two groups had the biggest hit to their net income in 1996. Cotton cooperatives were the only other group that had a decline in return on total assets. However, cotton cooperatives continued to have the highest ratio of any group, 18.3 percent. All of the other commodity groups realized increases in return on asset ratios. However, they did not increase enough to overcome the drop in the cotton, grain and fruit/vegetable groups. Diversified and rice cooperatives had the largest increase in their return on assets.

    The last ratio compared in this report is the return on member equity. It is calculated by dividing the net margins after interest and taxes by total member equity. Interest is a return to creditors while taxes are a return to government, so interest and taxes must be removed to get the true return on equity.

    After four years of improving returns on member equity, the trend dropped in 1996. Forty-seven of the 100 largest agricultural cooperatives had lower returns to member equity in 1996. Most were found in the grain and fruit/vegetable cooperative groups. Within the other commodity groups, there were enough gainers to offset any cooperatives with declining return on member equity. The largest gains made by the different commodity groups were the dairy, diversified and the poultry/livestock cooperatives. Sugar cooperatives finally had positive returns to member equity given that the prior two years they averaged negative returns.

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