What financial statements say about your farm
Three RBC Royal Bank account managers outline how they analyze clients’ ability to service debt.
If you’ve ever taken out a farm business loan, chances are you dropped off a set of financial statements with your financial
institution’s account manager. Ever wonder what they’re looking for?
According to three RBC bankers – Sharon Bucsis and Lanny Dewan in Regina, and Martyn Donnelly in Charlottetown – an account manager’s focus is squarely on the
client’s ability to service their current or proposed debt obligations. And while financial statements are critically important, they all agree the human element is
an integral part of the credit assessment.
Bucsis explains that financial statements are typically requested as part of the annual credit review process for existing credit clients, or as a way to get to know
the businesses of new clients. Between annual reviews, interim statements are helpful if the client is engaged in a significant operational change. These
face-to-face reviews are intended to foster open, two-way communication.
“We want clients to know where we’re coming from when we establish their credit score,” says Bucsis.
Accrual reveals, cash obscures
As an industry, Canadian agriculture is somewhat unique for its continued use of cash-basis accounting. In cash-basis accounting, transactions are based on
when cash changes hands. Accrual-basis accounting, which recognizes income when earned and expenses when incurred, disallows many year-end income
reducing strategies such as pre-buying the following year’s inputs. To be truly relevant, financial statements should be prepared according to the accrual
method of accounting. For clients who do their books strictly on a cash basis, RBC account managers have a software tool that adjusts the data to accrual.
“There’s a wide range in terms of the quality of financial information we get,” says Donnelly. “We see everything from audited financial statements to tax
returns. We encourage clients to see the value of having accountant-prepared financial statements. They give a much clearer picture of the business, and in
that respect they are very important to the client’s future decision-making.”
Debt service coverage ratio
In terms of financial statement analysis, what matters most to the account manager is the client’s ability to service debt. An important measure of this
ability is the debt service coverage ratio.
As Dewan explains, you take the net operating income or EBIDTA (earnings before interest, depreciation, taxes and amortization) and divide it by total debt obligations.
The resulting figure gives a quick and meaningful snapshot of how well the client’s income can handle their debt.
“We will look at the three-year average of debt service coverage,” says Dewan, “and make allowances for depreciation and interest expenses.”
Cash is king
There’s an old saying in financial analysis: profit and loss are opinions, but cash is a fact. Bucsis, like her colleagues, places great emphasis on the cash flow statement.
“Cash is king when it comes to repaying debt,” she says. “We also look closely at the income and expense statement. If there’s been a 10 per cent or greater
change in either income or expenses year over year, we’d like to know why. Very often, it can be understood as a one-time event, but it could also signal
a trend worth watching.”
The three bankers, consistent with industry practice, will use the client’s financial statements to calculate several essential financial ratios. One is the
debt-to-TNW ratio, which divides total liabilities by the client’s Total Net Worth.
Another is the current ratio, which measures how well the business can meet its short-term obligations. To arrive at the current ratio, simply divide
current assets (cash, receivables, inventory) by current liabilities (those due within the next 12 months). Subtract current liabilities from current assets and you have the business’s working capital, another crucial creditscoring measure.
“If working capital and current ratio appear to be tightening,” says Dewan, “it might be advisable to turn some shorter-term debt into longer-term debt. The key thing is to strike a balance between having enough working capital on hand while maintaining adequate debt service coverage.”
The current ratio is considered a more significant measure in farm sectors with a higher degree of commodity price volatility, such as cash crops. In a supply-managed
sector like dairy, there’s less price volatility so the current ratio has relatively less importance.
Among incorporated farms, account managers will observe the movement of funds between the Corporation and its shareholders: dividends, shareholder
loans and living allowances. While such payments can be advisable for tax purposes, your banker might perceive a problem if these actions appear to reduce the farm’s debt service coverage.
The limits of financial analysis
Financial statements are a key indicator of the farm’s financial status and operational direction. That’s no substitute, however, for getting to know
the clients as people.
In fact, financial statements often carry less weight than the human elements. Donnelly explains that a client’s total risk assessment is based 35 to 55 per cent
on financial statements and their analysis. The remaining 45 to 65 per cent is based on factors like the client’s management style, position in the industry and a
volatility rating assigned to the client’s farm sector.
“Financial statements are a very important tool, but they are really just a starting point for how we work with clients,” he says.
Bucsis agrees. At a certain point, it’s vital to put the hard numbers aside and consider the softer factors that influence the client’s success. She believes the old-fashioned farm visit is as important as ever in the producer-banker relationship.
Says Bucsis: “The financial analysis and the farm visit work together to help us understand the farm operation’s financial goals.”
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