The equity to asset ratio tells us how much a farmer’s operation has been financed through their own equity, as opposed to financed through debt.
The equity to asset ratio is one of the solvency ratios used in farm financial analysis.
Equity to Asset Ratio Formula
Equity to Asset Ratio = Total Equity ÷ Total Assets
This article is a part of our series on Farm Financial Performance Ratios.
Description
The equity to asset ratio is a financial metric that tells a farmer how much of their farm is financed by their own investment (equity) compared to how much is financed by debts (liabilities).
It’s calculated by dividing the total equity of the farm by the total assets of the farm. Here’s a simple way to understand it:
Imagine your farm is like a pie, and the whole pie represents everything your farm owns—all its assets, like land, equipment, and livestock. Now, if you had to divide this pie into parts based on who actually owns these assets, one part would be yours (equity), and the other part might belong to the bank or other creditors (liabilities).
The equity to asset ratio tells you the size of your slice of the pie compared to the whole pie. If your slice is bigger, it means you own a larger portion of your farm outright, and less of it is financed by debts.
A higher ratio is generally seen as healthier because it means you rely less on borrowed money, which can offer more stability and less financial risk. If the ratio is lower, it suggests you have more debts relative to your assets, indicating potential vulnerability to financial downturns or changes in market conditions.
Calculating the Equity to Asset Ratio
As the name implies, the equity-to-asset ratio is calculated by dividing the total equity by the total assets.
Equity to Asset Ratio = Total Equity ÷ Total Assets
To determine the equity to asset ratio, you will need to find the Total Assets and Total Equity on a balance sheet. See the example to the right.
Equity represents ownership in an asset or business. In farming, it’s the value of the farm’s assets owned outright by the farmer after deducting any liabilities or debts.
Assets typically include items such as cash, inventory, livestock, land, machinery and equipment. Generally this is anything which is owned by the farmer.
A full breakdown of Assets and Equity can be found on an agricultural balance sheet.
Guided Example
Say for example, John, a farmer, has total assets of $500,000, which can be a combination of current and non-current assets. Also assume that he has put in $200,000 of his own money, either through startup funds or retained earnings.
To calculate a equity to asset ratio, start by taking our formula:
Equity to Asset Ratio = Total Equity ÷ Total Assets
Then plug in the total equity and total assets:
Equity to Asset Ratio = $200,000 ÷ $500,000
Using our formula, we arrive at 40% as the equity to asset ratio.
40% = $200,000 ÷ $500,000
What this tells us is that 40% of John’s assets have been financed in some way through his own inputs, either contributed capital (startup money) or retained earnings. This is good, in that John has a reasonable level of equity in the operation.
Ideal Equity to Asset Ratio for Farmers & Ranchers
The ideal equity to asset ratio for a farmer varies depending on factors such as the farmer’s financial goals, risk tolerance, and industry standards. However, generally, a higher equity to asset ratio is preferred as it indicates a stronger financial position and less reliance on debt.
Based up broad industry benchmarks, farmers should strive to attain an equity to asset ratio of 40% or higher.
A higher ratio indicates a lower degree of leverage, which means the farmer is less reliant on debt to finance their assets. While some level of debt can be useful for growth and operations, a higher debt-to-asset ratio can also indicate higher financial risk, as the farmer must ensure enough cash flow to meet debt obligations.
Conversely, a higher ratio suggests that the farmer has a greater equity stake in their operation, potentially indicating a stronger financial position with less reliance on borrowed funds.
How to Improve Your Equity to Asset Ratio
Improving the equity-to-asset ratio is crucial for farmers aiming to enhance their financial stability and reduce reliance on external financing. To improve your equity to asset ratio, your strategy should be aimed at either increasing your equity or decreasing your liabilities.
To Decrease Debts
- Pay Down Debt in a Timely Manner. Any reputable banker will provide a farmer with adequate financing at adequate terms. Over time, as one decreases debt, the debt to asset ratio will improve.
- Avoid Acquiring New Debt. While sometimes necessary for growth or survival, taking on new debt should be approached with caution. Farmers should evaluate the necessity and terms of new debt carefully to ensure it doesn’t adversely affect their debt-to-asset ratio.
- Negotiate better payment terms. Negotiate longer payment terms with suppliers to delay outgoing payments, thus extending the timeframe for settling accounts payable.
- Refinance short-term debt. Consider refinancing short-term loans with longer-term options to reduce the portion of debt due within the next year, thus lowering current liabilities.
To Increase Equity
- Retained Earnings. Reinvest profits back into the farm rather than distributing them as dividends to increase
- equity over time.
- Personal Investment. Inject personal funds into the farm as additional equity capital.
- Asset Appreciation. Increase the value of farm assets through improvements, upgrades, or increased productivity, which indirectly boosts equity.
How the Equity to Asset Ratio is Used
The debt to asset ratio is a crucial financial metric that measures the proportion of a company’s assets that are financed by debt. This ratio is important for several reasons, particularly in assessing a company’s financial health, risk level, and operational efficiency.
Farmers and Ranchers us the debt to asset ratio to understand the overall health of their operation. If the debt to asset ratio continues to grow, that is a sign that a higher and higher proportion of debt is used to provide the capital to run the operation.
Higher debt means higher interest payments. While debt in some cases can be beneficial, it is important to keep the debt to a reasonable and economically sustainable level.
Similarly, lenders use the debt to asset ratio to assess the overall debt burden placed upon a farmer. This debt in turn must be sustained by the operation. If a farmer is over encumbered, also called overleveraged, there is risk of default. This is especially true if there are adverse conditions which impact the borrower. Conversely, farmers and ranchers borrowing from a bank may get preferred or better rates when the lender knows there is less debt and a greater certainty of repayment.