By: Jim Byars, vice president of commercial lending and Steve Zimmerman, senior tax accountant
In challenging economic times, like those being experienced today, it is more important than ever for producers to monitor their operational efficiency by paying close attention to the imperative information that reveals the financial condition of your operation.
For this, one of the simplest measurements to assess is your breakeven point when revenue fully covers costs. Most producers inherently sense whether they are breaking even or not by watching their working capital level and knowing whether they have enough money in the bank to pay all their bills each month. An actual assessment of costs and revenues will provide an even deeper insight. When the data shows that break-even is not being met, the producer knows it needs to reduce costs or increase revenues for the operation to be viable long-term.
Comparing your data to both prior performance and industry benchmarks also provides a degree of insight. For dairies, for example, this typically means analyzing three- to five-year trends in earnings, feed costs and labor cost, typically by hundredweight or cow. To compare performance with industry standards, multiple resources exist, such as the peer comparison information GreenStone Farm Credit Services has compiled, several accountancies provide relevant regional data across a broad number of producers, and universities also offer benchmarking data. It is important to be mindful when comparing your operation to other producers, though, since the type of operation and its associated costs can vary greatly. For example, a dairy that buys feed and replacement cows will have a different cost structure than one that raises its own replacement cows and has ample pastureland; a grain producer who rents land will have different costs than one who has purchased land; a larger operation of any type likely benefits from economies of scale, particularly regarding labor costs per unit.
Another means to measure operational efficiency is analyzing your profit and loss (P&L) statement with accrual adjustment, which shows the sources of income and operating expenses. Comparing P&L statements over time reveals how the operation is trending, as does analyzing the largest several expenses in proportion to revenues. For example, if you run a dairy operation, feed purchases should total no more than one-third of revenue and labor no more than 10 percent of total revenue; for grain and similar operations, no more than 25 percent of revenue should go to inputs like seed and chemicals.
At a deeper analytical level, a series of key financial ratios offers significant insight: divided into five categories, these ratios offer an objective assessment of an operation’s performance at a given point in time.
Working Capital, the difference between current assets and current liabilities, is the main measurement of liquidity, and producers should seek a 2:1 ratio of assets to liabilities. Another liquidity measurement is the Working Capital Over Revenue ratio, with a goal of holding one-third of farm production value as current assets. If this level is not being achieved, the producer should find ways to increase inventories and reduce current liabilities, perhaps by working with your financing partner to consider options like restructuring debt to stretch payments over a longer time period.
An operation’s solvency is measured through the Equity to Asset ratio, which measures how much equity, or net worth, a producer has in relation to assets. For every $100 in assets, an operation should have $50 in equity. A lower ratio often indicates the assets are borrowed against, and producers in this situation should likely focus on repaying debt or liquidating assets.
Profitability measures include the Rate of Return on Farm Assets, which should be near to the interest rate earned on a typical savings account. In today’s low-interest rate environment, any rate greater than 4 percent is positive for the producer; if the percentage is less than this, the producer should focus on generating more profitability by increasing margins or selling off non-performing assets and either paying down debt or investing in assets that will generate more profitability. Another profitability measure is the Rate of Return on Farm Equity, more common for producers seeking investor money, but also providing decision-making support – if this rate is lower than desired, again the solution is to increase the profit margin and/or reduce the debt load.
Two ratios serve to measure financial efficiency: the Asset Turnover Ratio and the Operating Expense Ratio. The former measures an asset’s ability to generate revenue, and the ideal is a 1:1 ratio in an asset’s first year, meaning that every dollar invested in the asset generates a dollar in revenue. This is extremely rare in agriculture, and a more realistic target for producers is a 30 or 40 cent return on each dollar invested; operational decisions such as renting land rather than purchasing it as an asset can improve this ratio if needed. The Operating Expense Ratio demonstrates operating expenses in relation to the revenue generated. If, for example, an operation generates $100 in revenue and only spends $10 on operating expenses, it has a 90 percent operating efficiency. For agriculture, a level of 65 – 75 percent is acceptable. If an operation’s ratio is not at this favorable level, the first solution is to reduce operating expenses, but if costs have been cut as far as possible, working to generate more revenue at the same cost level will be key, either by increasing productivity, marketing for a better price or selling more units.
Repayment Capacity is a critical measurement for lenders, as it conveys a borrower’s ability to repay their loans. Typically, a 1:1 ratio is acceptable, meaning that the producer is generating exactly enough revenue to repay their debts; however, a better goal is ratio of 1.15 – 1.25, which indicates that the producer is generating excess revenue that can be added to working capital or invested in strong performing assets.
As you know, using financial data to measure operating efficiency is complex, and can seem overwhelming to agricultural producers who much prefer managing and caring for their farms and herds. However, the financial report card all of this data provides can help you make wiser operational decisions.
Reviewing your critical financial data is an ongoing responsibility for sound operational management. At GreenStone, we typically sit down with our customers quarterly or even monthly, depending on the type of operation. During these meetings, our experienced staff drill down on the relevant data points to gain and share a comprehensive understanding of the financial health of the operation, identifying strengths and weaknesses, where improvements need to be made, and in some cases recommending other professionals to assist in making the right decisions to allow your operation to thrive.
