Agriculture Reference
In-Depth Information
performance. If a particular facet of the business is headed for trouble, a change in a ratio can
only sound a warning. Even a drastic change in a given ratio may not isolate and identify the
actual cause of the problem. More often than not, additional analysis is required before
the appropriate corrective action can be taken. Care must be taken to ensure that all com-
parisons are between genuinely similar elements. Some of the more general limitations of
fi nancial ratios are discussed below. In addition, each specifi c ratio may have limitations that
are unique to its use, and many of these were highlighted above.
Changes in the accounting methods of the agribusiness itself, or differences between the
fi rm's accounting methods and those of similar fi rms, may limit the use of ratios. If BF&G
were to change the way it values inventory, assets, and/or change its depreciation method,
comparisons of its ratios with ratios of previous periods would lose validity.
Time factors also pose a signifi cant constraint on ratio analysis. Financial statements are
indicative of one period of time. Comparing one monthly period to a different monthly
period or to a yearly statement can present a distorted view of the business, because of the
seasonality aspects of some businesses. Comparing BF&G's January accounts receivable as
a percentage of current assets to its July accounts receivable percentage would provide a
comparison that would be virtually useless, because of the seasonality aspects of the busi-
ness. Bad information or analysis can be worse than no information at all.
Also, extraordinary items can distort the fi nancial ratios for a fi rm. A one-time revenue or
expense is an example of such a distortion. The gain or loss resulting from the extraordinary
sale of a capital item can distort fi nancial ratios, since this sale is not part of the routine busi-
ness for the fi rm.
As mentioned in
Chapter 9
, the use of income statement data using the cash basis of
accounting can result in tremendous variation and distortion in profi tability and effi ciency
ratios. Data from income statements prepared using the accrual basis of accounting should
be used whenever possible for calculating fi nancial ratios.
The profi tability analysis model
Three fundamental measures of how well the business is being managed are (1) return on sales,
(2) return on assets, and (3) leverage. The combination of these very important fi nancial rela-
tionships into a single ratio, return on equity or ROE, provides one of the most useful fi nancial
tools available to measure the performance of the agribusiness and to assess the skill and abil-
ity of the management team. Many sophisticated managers, bankers, investors, and boards of
directors depend on this conceptual measure as the primary gauge of a business's success.
ROE in perspective
Figure 10.1
shows the step-by-step process of developing an ROE analysis model. This
model is called the profi tability model or profi tability analysis system. Sometimes, this type
of analysis is also referred to as the DuPont model. ROE is measured here in terms of return
on equity. The diagram illustrates the three key component ratios which individually and
together affect ROE. Management can use this chart as a tracking system or early warning
system to determine when action is needed if the fi rm is to continue to move toward its
ROE goals.
Figure 10.
1 indicates that ROE is directly affected by (1) the earnings from sales (net
income after taxes divided by net sales), (2) the intensity assets are used, measured by asset
turnover (net sales divided by total assets), and (3) the use of outsiders' funds to expand the
