Financial Performance Analysis for Cooperative Directors: Ratio Analysis and Benchmarks | Study notes Business Accounting

Division of Agricultural Sciences and Natural Resources • Oklahoma State University

AGEC-997

Phil Kenkel

Bill Fitzwater Cooperative Chair

Boards of Directors have the responsibility to evaluate the

annual audit and to track the financial successes or failures of

the cooperative. This means the directors need to not only be

able to read the financials and see trends, but they also must

be able to understand the underlying causes of those trends.

The board must be able to compare their cooperative financials

to industry benchmarks, peer performance, and company pro-

jections. They will then use this information to build strategic

plans and financial projections for the coming year.

Much of this analysis is “common sense” analysis. Directors

should be able to scan the cooperative’s financial statement

and identify factors that impact each statement. The factors that

impact long-term growth are most important. The cooperative

should pay particular attention to the local savings (loss) of

the cooperative. This means that the cooperative only looks

at ratios calculated from the earnings and expenses of the

main cooperative, not the patronage received from regional

investments.

Once this “common sense” analysis is complete, the

board can move on to a more in depth study of the coopera-

tive, utilizing “common size” analysis, peer analysis, and an

in-depth ratio analysis.

Common Size Analysis

A common size analysis scales the financials into a per-

centage of sales for the income statement and a percentage of

total assets on the balance sheet. The scaling effect highlights

the most important expense areas and can reveal problem

areas that may not have been noticed before. It also provides

a way to compare year-to-year variations in financials.

Peer Analysis

A peer analysis involves comparing the cooperative’s

performance with the performance of other cooperatives of

a comparable size, industry, and primary business type. For

example, if the company is an Oklahoma grain cooperative

with $3 million in sales last year, it could compare itself to the

average performance of other Oklahoma grain cooperatives

with sales ranging from $1 million to $5 million.

This is an excellent tool for highlighting the strengths and

weaknesses of cooperatives. The peer data to compare to can

be obtained from universities, state statistic services, or the

company’s banker will have some of the data.

Ratio Analysis

Ratio analysis is perhaps the most common method of

financial analysis and it is this method on which the most weight

is placed. Ratio analysis provides a way cooperatives can high-

Financial Performance

Analysis for Directors

light strengths, as well as problem areas, and positive/negative

trends. It also allows for the company to better compare to

peer financial results and to industry benchmarks.

Benchmarks are considered to be acceptable financial

results in the particular industry in which the cooperative op-

erates. The peer analysis shows how the company is doing

compared to its peers; however, if the industry is in a slump,

it may make the financials look better than what it is actually

doing. A benchmark analysis shows the cooperative and its

peers where the industry should ideally be. Some of these

ratios include:

• Efficiency and Turnover Ratios: includes accounts re-

ceivables turnover, inventory turnover, and total assets

to sales;

• Expense Ratios: includes personnel to gross income,

fixed expenses to gross income, and bad debt to credit

sales;

• Profitability Ratios: includes local savings margin, local

savings to local assets, return on assets, and return on

net worth; and

• Debt Ratios: includes debt service coverage, debt to

asset ratio, and local leverage.

In the following paragraphs we will go over some of the

more commonly used financial ratios, and how they interrelate.

At the end of this paper is a supplement that provides calcula-

tions for these ratios as well as the benchmarks associated

with that ratio.

Efficiency and Turnover Ratios

Efficiency and Turnover ratios measure how efficient a

company is at collecting accounts receivables and rotating

inventory. These ratios measure how well a cooperative is

using its resources or if improvements could be made. The

main ratios, as listed earlier, measure: how efficiently a co-

operative is spending its money relative to how much money

it is making, and how efficiently the cooperative is using its

assets to generate sales.

Accounts Receivable Aging

The accounts receivables turnover ratio (also called ac-

counts receivable aging) measures how often accounts are

paid off in a year. The benchmark for this ratio is usually 30

days, meaning that on average, members pay off their accounts

every month. However, this will vary with the credit terms of

Oklahoma Cooperative Extension Fact Sheets

are also available on our website at:

http://osufacts.okstate.edu

Oklahoma Cooperative Extension Service

Partial preview of the text

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Division of Agricultural Sciences and Natural Resources • Oklahoma State University

AGEC-

Phil Kenkel Bill Fitzwater Cooperative Chair Boards of Directors have the responsibility to evaluate the annual audit and to track the financial successes or failures of the cooperative. This means the directors need to not only be able to read the financials and see trends, but they also must be able to understand the underlying causes of those trends. The board must be able to compare their cooperative financials to industry benchmarks, peer performance, and company pro- jections. They will then use this information to build strategic plans and financial projections for the coming year. Much of this analysis is “common sense” analysis. Directors should be able to scan the cooperative’s financial statement and identify factors that impact each statement. The factors that impact long-term growth are most important. The cooperative should pay particular attention to the local savings (loss) of the cooperative. This means that the cooperative only looks at ratios calculated from the earnings and expenses of the main cooperative, not the patronage received from regional investments. Once this “common sense” analysis is complete, the board can move on to a more in depth study of the coopera- tive, utilizing “common size” analysis, peer analysis, and an in-depth ratio analysis. Common Size Analysis A common size analysis scales the financials into a per- centage of sales for the income statement and a percentage of total assets on the balance sheet. The scaling effect highlights the most important expense areas and can reveal problem areas that may not have been noticed before. It also provides a way to compare year-to-year variations in financials. Peer Analysis A peer analysis involves comparing the cooperative’s performance with the performance of other cooperatives of a comparable size, industry, and primary business type. For example, if the company is an Oklahoma grain cooperative with $3 million in sales last year, it could compare itself to the average performance of other Oklahoma grain cooperatives with sales ranging from $1 million to $5 million. This is an excellent tool for highlighting the strengths and weaknesses of cooperatives. The peer data to compare to can be obtained from universities, state statistic services, or the company’s banker will have some of the data. Ratio Analysis Ratio analysis is perhaps the most common method of financial analysis and it is this method on which the most weight is placed. Ratio analysis provides a way cooperatives can high-

Financial Performance

Analysis for Directors

light strengths, as well as problem areas, and positive/negative trends. It also allows for the company to better compare to peer financial results and to industry benchmarks. Benchmarks are considered to be acceptable financial results in the particular industry in which the cooperative op- erates. The peer analysis shows how the company is doing compared to its peers; however, if the industry is in a slump, it may make the financials look better than what it is actually doing. A benchmark analysis shows the cooperative and its peers where the industry should ideally be. Some of these ratios include:

Efficiency and Turnover Ratios: includes accounts re- ceivables turnover, inventory turnover, and total assets to sales;
Expense Ratios: includes personnel to gross income, fixed expenses to gross income, and bad debt to credit sales;
Profitability Ratios: includes local savings margin, local savings to local assets, return on assets, and return on net worth; and
Debt Ratios: includes debt service coverage, debt to asset ratio, and local leverage. In the following paragraphs we will go over some of the more commonly used financial ratios, and how they interrelate. At the end of this paper is a supplement that provides calcula- tions for these ratios as well as the benchmarks associated with that ratio. Efficiency and Turnover Ratios Efficiency and Turnover ratios measure how efficient a company is at collecting accounts receivables and rotating inventory. These ratios measure how well a cooperative is using its resources or if improvements could be made. The main ratios, as listed earlier, measure: how efficiently a co- operative is spending its money relative to how much money it is making, and how efficiently the cooperative is using its assets to generate sales. Accounts Receivable Aging The accounts receivables turnover ratio (also called ac- counts receivable aging) measures how often accounts are paid off in a year. The benchmark for this ratio is usually 30 days, meaning that on average, members pay off their accounts every month. However, this will vary with the credit terms of

Oklahoma Cooperative Extension Fact Sheets

are also available on our website at:

http://osufacts.okstate.edu

Oklahoma Cooperative Extension Service

AGEC-997-

the cooperative. Another benchmark that is more universal is that no more than 20 percent of accounts should be more than 60 days old, and no more than 5 percent should exceed the maximum days allowed by your credit policy. Accounts receivables aging can be improved by tightening the credit policy, placing historically troublesome accounts on a cash only policy, collecting past due accounts (by legal means if necessary for accounts that are unreasonably overdue), and writing off those doubtful accounts that the manager feels will never be paid off. Collecting accounts receivables can be hard in a cooperative, so most boards of directors pay close attention to this ratio. If a problem can be stopped before it becomes an issue for the cooperative, the needed changes can be implemented quickly and reasonably painlessly. Inventory Turnover Ratio Inventory turnover is another important issue because it reflects the number of times the inventory is sold out during the year. Management can discover sales trends, and what “dead inventory” items he/she is carrying by paying close attention to the inventory that is being sold out. The inven- tory turnover ratio measures the overall effectiveness of an inventory system. Reducing overall inventory levels, getting dead items out of the warehouse, and coordinating inventory between branches can improve it. Another more popular option is to increase sales through smart marketing. If this option can be accomplished, the cooperative can improve inventory turnover as well as other crucial ratios based on sales. Total Assets to Total Sales The total assets to total sales ratio measures whether a cooperative is efficiently using its assets to generate sales. Like the expense to sales ratio, it can be improved by increasing sales or by reducing unproductive assets. Most cooperatives have a “dead horse” asset that is kept, either because the members want to keep it or it provides a valuable service to the rest of the cooperative. Whatever the reason, these kinds of unproductive assets should be re-configured or removed because they put a drain on the cooperative’s profitability and productivity. Fixed Assets Cooperative is over invested in long term investments including plant equipment. This ratio can be improved by selling equipment or increasing sales. It is determined by sales divided by total assets. Expense Ratio Expense ratios measure the expense of the company for the past year. By using local ratios, the cooperative can remove the variability produced by the ups and downs of regional patronage refunds. It also prevents the cooperative from looking worse than it actually is, due to weak joint ven- tures, extraordinary losses, and regional stock write-downs. Fixed Expenses to Gross Income The fixed expenses to gross income ratio measures whether or not cooperative expenditures, such as buildings, are appropriate given the cooperative’s size (as measured by sales). It can be improved by either increasing sales or decreasing expenses. A decreasing trend in this ratio is better because it means your expenses are decreasing relative to your sales. Personnel to Gross Income The personnel to gross income ratio is a measure of how efficiently the personnel of the cooperative are being used. Human capital is a key part of a successful cooperative. The best people should be in the right positions where they can be the most productive. This ratio can be improved by reducing overtime of employees who are “milking the clock,” reducing unproductive employees, or encouraging productivity and margins without removing any employees.

Bad Debt to Credit Sales

The bad debt to credit sales measures the ultimate cost of the cooperative’s credit policy. This preferably averages less than a quarter of a percent. Many cooperatives charge an allowance for bad debts each year, then adjust for the actual amount. Bad debt expense estimate can be best calculated by averaging the actual amount of several years. Profitability Ratio Profitability measures do exactly what they say; they measure the profitability of the company for the past year and give indicators of how to further improve local profitability. A key term is that these financial ratios are local numbers. By using local ratios the cooperative can remove the variability produced by the ups and downs of regional patronage refunds. It also prevents the cooperative from looking worse than it actually is, due to weak joint ventures, extraordinary losses, and regional stock write-downs. Local Savings The local savings margin removes non-cash and cash patronage income, gains and losses on sales of assets, and income from joint ventures from the net profit (before tax) of the company. This gives the savings number that was actually generated by the local cooperative, without the income (loss) provided by outside sources. Joint venture income is becoming a big issue as many local cooperatives branch out and diversify. Most cooperatives participate in joint ventures that are substantially different than their core business (i.e. a grain elevator entering a joint venture in a convenience store). This income would clearly be taken out in calculating local savings. However, there are instances where the joint venture may be so closely related to the cooperative’s core business that the joint venture income will be included in the local savings (i.e. a grain elevator enter- ing a joint venture in a grain marketing alliance). If in doubt whether or not joint venture income would be included in local income, consult your auditor or lender. Local Savings to Local Assets Local savings to local assets summarizes the return your cooperative is getting from its assets. It can be improved by increasing margins, eliminating unproductive assets, or

AGEC-997-

Oklahoma State University, in compliance with Title VI and VII of the Civil Rights Act of 1964, Executive Order 11246 as amended, Title IX of the Education Amendments of 1972, Americans with Disabilities Act of 1990, and other federal laws and regulations, does not discriminate on the basis of race, color, national origin, gender, age, religion, disability, or status as a veteran in any of its policies, practices, or procedures. This includes but is not limited to admissions, employment, financial aid, and educational services. Issued in furtherance of Cooperative Extension work, acts of May 8 and June 30, 1914, in cooperation with the U.S. Department of Agriculture, Robert E. Whitson, Director of Cooperative Extension Service, Oklahoma State University, Stillwater, Oklahoma. This publication is printed and issued by Oklahoma State University as authorized by the Vice President, Dean, and Director of the Division of Agricultural Sciences and Natural Resources and has been prepared and distributed at a cost of 20 cents per copy. 0107 GH. Conclusion Today’s cooperative director is faced with a changing business form and members that demand transparency in the cooperatives financials. As the ambassadors of the members, it is the duty of directors to provide this transparency and watch for damaging financial trends. Below is a supplement that provides the calculations for the major ratios that were discussed here as well as some benchmarks. Please review it and direct any additional questions to one of the sources mentioned earlier. Common Ratio Calculations and Benchmarks Ratio Benchmark Turnover and Efficiency Ratios Inventory Turnover Farm Store/ Hardware: > 5- Cost of Goods Sold Feed: >10- ÷ Average Inventory Bulk Fertilizer: > 2- Crop Production:> 7- Bulk Fuel: >15- Efficiency Ratios Operating Expenses To Sales Operating Expenses <10% ÷ Sales Sales to Total Assets >4- Sales ÷ Total Assets Personnel expense To Gross Income 30% - 40% Fixed Expenses to Gross Income 25%-30% Other Expenses to Gross Income 25% Bad Debt/sales < .25% Profitability Ratios Local Savings Margin 1.0% of Grain Sales Profit before tax and 2.5% of Supply Sales − Non-cash patronage income − Cash patronage income − Gain (loss) on asset sales − Income from joint ventures ÷ Total Sales Local Savings To Local Assets 8% Local Savings ÷ Local Assets Sales Trend 5% (Current Sales-Prior Sales)/Prior Sales Ratio Benchmark Return On Local Assets 8% or Greater Pre-Tax Profits ÷ Local Assets Return On Net Worth >10% (Also Called Return on Equity) Pre Tax Profit ÷ Total Net Worth Return on Local Equity

10% Local savings/members equity Debt Ratios Debt Service Coverage Greater than 2. Available Cash Flow ÷ Debt Payments Debt/Total assets < 50% Local Leverage <30% - 40% long Term Debt ÷ Net Worth − Regional Investments Local Equity/Total Equity > 80% (Equity-Regional Investments)/Total Equity Liquidity Ratios Working Capital Current Assets > (1.5% of Grain Sales − Current Liabilities +2.5% of Supply Sales) Current Ratio Current Assets 1.5 for supply co-ops ÷ Current Liabilities up to 2.0 for grain co-ops Fixed assets/total assets < 33% Days Accounts Receivable <30 – 45 days Average Accounts Receivable <20% over 60 days ÷ Average Daily Credit Sales Accounts Receivable over 60 days < 20%

Financial Performance Analysis for Cooperative Directors: Ratio Analysis and Benchmarks, Study notes of Business Accounting

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Download Financial Performance Analysis for Cooperative Directors: Ratio Analysis and Benchmarks and more Study notes Business Accounting in PDF only on Docsity!

Division of Agricultural Sciences and Natural Resources • Oklahoma State University

AGEC-

Financial Performance

Analysis for Directors

Oklahoma Cooperative Extension Fact Sheets

are also available on our website at:

http://osufacts.okstate.edu

Oklahoma Cooperative Extension Service

AGEC-997-

Bad Debt to Credit Sales

AGEC-997-