Using Solvency Ratios to Predict Future Profitability

Abstract

Solvency ratios are normally used as an indicator of the long-term viability of the farm business. Farms with high leverage have a greater likelihood of going bankrupt. Bankruptcy occurs because a farm loses its equity. However, for a farm to lose equity, it must generate negative profits or family living withdrawals must exceed profits and any equity increases. In either case, low profitability is likely a major factor in a farm losing equity. This might imply that highly leveraged farms, which pay more in interest expense, are earning less profit than those farms without debt. Thus it might be possible to predict future profitability based on solvency ratios. This paper tests that hypothesis but finds a naive model of looking at past profit to predict future profits works better than using solvency ratios.