Equity, and what makes it go up and down

Equity is the part of the business that's yours. It's total assets less total liabilities. If a farm owns $5 million and owes $2 million, equity is $3 million.

The equity ratio

A dollar figure on its own doesn't say much, because farms come in all sizes. So people also look at the equity ratio: equity divided by total assets, shown as a percentage. In the example above it's $3 million divided by $5 million, which is 60%.

A higher equity ratio means you own more of the business yourself and owe less. Each lender has its own view of what's comfortable, and it depends on the cashflow too. A farm with lower equity but strong, steady cash can be a better borrower than one with high equity that loses money.

What makes equity go up

• Profit you keep in the business. Profit that isn't taken out as drawings builds equity.
• A rise in asset values, such as land going up in value.

Paying down debt from profit is part of the first point. The profit builds equity, and using it to repay debt means you owe less.

What makes equity go down

• Losses.
• Drawings bigger than profit. If the family takes out more than the farm earns, equity falls, even in a year that shows a profit.
• A fall in asset values, such as land or livestock prices dropping.

Earned growth and paper growth

It pays to know which kind of growth you've had. If equity rose only because land values went up, the farm hasn't earned anything extra. The land just got dearer. If values fall later, that equity can go just as fast. Growth from profit you've kept is the kind you can rely on.

Why the bank cares

Equity is your buffer. It stands between the bank's loan and a loss if things go wrong. That's why the bank works out your equity at current values, not book values, each time it reviews your loans.

Track it yourself

Once a year, fill in a statement of assets and liabilities at fair current values. Our assets and liabilities template sets it out. Write down your equity and equity ratio, and compare them with last year. Then split the change into profit kept and changes in values, so you know what really happened.

The bank ratios card has the equity ratio and the other main ratios on one page.