Judging Farm Performance

For some farm producers, winter often allows a time of reflection of the performance of the harvest and planning for the next year.  For others where the work continues throughout the season, the close of one year and the beginning of another is a good time to perform some planning tasks.  There is value in that as my mom used to say, "Prior planning prevents poor performance."  Those words rang true in my ears as I finished a test in school.  How well I was prepared, often resulted in how well or poorly I did on the test.  But as I look at my career in finance, that saying applies to your farm producer as well.  It is a fearful situation when the farmer is just "winging it" and hoping for the best.  Oftentimes, the result is like my results on the test that I did not prepare for.

So what are some of the better ways to judge farm performance?  Clearly, one way is to focus on the revenue per acre or revenue per head.  But this can skew acutal performance as it does not take into account any input costs.  A farm with a $150 revenue per acre with cost of $50 is better than one with $200 revenue per acre with costs of $125.

I would suggest that some of the financial ratios we utilize in company analysis can also be useful here with farm analysis.  But a warning here is that just like when reviewing a company, none of these ratios should be used in a vacuum.

The first measure is Return on Equity = (Net Farm Income from Operations less Value of Unpaid Operator and Family Labor ) divided by Average Total Farm Equity.  This ratio measures the rate of return on the owner's equity capital used in the agricultural operation.  In high profit years the top third producers had ROEs as follows:  pork 23%, grain 18%, dairy 6%, and beef 12%.  The worst third had ROEs that averaged from 4.5% to -5%.

Focusing on ROE alone can overstate the performance of a highly leveraged producer.  This is since the denominator is abnormally low with the lack of equity in the farm.  So it is useful to also consider Return on Assets = (Net Farm Income from Operations less Value of Unpaid Operator and Family Labor) divided by Average Total Assets.  Here it may be good to have both a market valued balance sheet (which is useful in comparing one farm ot another) and a cost valued balance sheet (useful in comparing a farm to itself over time).

The Operating Profit Margin Ratio = (Net Farm Income From Operations + Farm Interest Expense - Value of Unpaid Operator and Family Labor) divided by Gross Farm Revenues.  The OPM measures the return on capital per dollar of gross farm income.  A farm can increase profits by increasing the profit per unit produced (with higher revenue or lower unit costs) or by increasing the production volume while mantaining the profit per unit.  OPM focuses on the first factor while Asset Turnover Ratio will focus on the later one.  Asset Turnover = Gross Farm Revenue divided by Average Total Farm Assets.  It is important in both these ratios to use the accrual basis. Some producers may deliberately hold back product from the market in seeking a better price or for tax planning.  The cash basis can provide some skewed numbers.

Another measure is change in earned net worth.  This is the accrual net income after taxes, less owner withdrawals.  In the business world it is the change in retained earnings.  This shows how the owners use their net income.  It will equal the change in retained earnings.  This shows how the owners use net income.  It will equal the change in the cost basis of net worth, with the exception of any capital contributions or distributions.

Sometimes, the profitable producer will go down the slippery slope of financial trouble when they extract more money from the farm than what it produces.  In these cases, it is important to note the "toy factor" or new cars, planes, tractors, etc. that lie around the ranch and have been purchased from the farm assets.  While there is nothing wrong with toys, there is a problem if the earnings do not support them.

There is also the trap of the farmer or rancher only looking at changes in market value net worth without questioning the actual change in owner equity of the farm.  Is the increase in equity from a windfall in land prices, which would have no relations to operating earnings?  Is your client a good or poor operator, a good or poor farm asset investor, both, or none?--Phil Love