University of Wisconsin Center for Cooperatives
Rural Cooperatives, November/December 1997, pp. 11-15
Published by the Rural Business and Cooperative Development Service
Leveraging the Future?
Higher Debt Levels Among Large Ag Co-ops May Be Cause for Concern
David S. Chesnick
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 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
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.
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
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.
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.
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.