Farmers who have a large investment in land, machinery, livestock, and equipment need to keep informed about the financial condition of their operations. Some useful measures of financial performance can be calculated from information found in most farm record books and accounting programs.
These measures can help farmers assess the profitability, debt capacity, and financial risk currently faced by their businesses. The measures presented in this article, written by Iowa State University extension economist Alejandro Plastina, are based on guidelines of the Farm Financial Standards Council and are used by most agricultural lenders and farm accountants.
Types of Measures
Five different areas of financial condition are measured. Values for the farm financial measures should be calculated for several years to observe trends and to avoid making judgments based on an unusual year.
- Liquidity refers to the degree to which debt obligations coming due can be paid from cash or assets that soon will be turned into cash. This is measured by the current ratio, the amount of working capital, and the amount of working capital per dollar of gross revenue. A more thorough analysis of liquidity can be made with a cash flow budget. Farms with good liquidity typically have current ratios of at least 3.0 or higher. Dairy farms or other farms that have continuous sales throughout the year can safely operate with a current ratio as low as 2.0, however. Conversely, operations that concentrate sales during several periods each year, such as cash grain farms, need to strive for a current ratio higher than 3.0, especially near the beginning of the year.
- Solvency refers to the degree to which all debts are secured, and the relative mix of equity and debt capital used by the farm. The total debt-to-asset ratio is one of several ratios used to measure solvency, all of which are based on the same relationship of assets, liabilities and net worth. Total debt-to-asset ratios tend to be higher for larger farms and for farms that specialize in livestock feeding.
- Profitability refers to the difference between income and expenses. One important measure of profitability is net farm income. Annual rates of return on both equity capital and total assets also can be calculated and compared to interest rates for loans or rates of return from alternative investments.
Operating profit margin is equal to the dollar return to capital divided by the value of farm production each year. Ratios have averaged about 25 to 30 percent in recent years. High profit farms have had ratios of 35 percent or more, while low profit farms have had ratios of less than 15 percent. Farms that hire or rent assets such as labor, land, or machinery will have a lower operating profit margin because operating costs are higher. However, they will usually generate a larger gross and net income. Farms with owned or crop share rented land will have a higher operating profit margin because they have lower operating expenses.
Another common measure of profitability is earnings before interest, taxes, depreciation, and amortization, abbreviated as EBITDA. It shows how many dollars are available for debt repayment.
- Financial efficiency ratios show what percent of gross farm revenue went to pay interest, operating expenses, and depreciation, and how much was left for net farm income. The asset turnover ratio measures how much gross income was generated for each dollar invested in land, livestock, equipment, and other assets. Asset turnover ratios for typical farms are about 30 to 40 percent, but they can range from 20 to 30 percent for low profit farms and up to 40 to 50 percent for high profit farms. The asset turnover ratio measures the efficient use of investment capital while the operating profit margin ratio measures the efficient use of operating capital. Because they are substitutes for each other (owned and rented land, for example), farms that are high in one measure may be low in the other.
- Repayment capacity measures show the degree to which cash generated from the farm and other sources will be sufficient to pay principal and interest payments as they come due. The term debt coverage ratio should at least be greater than 1.0, and the capital debt repayment margin should be large enough to cover any possible shortfalls in cash flow that cannot be paid from savings or other sources of short-term liquidity.
Using Benchmarks to Navigate Financial Future in Agribusiness
The agriculture industry is historically volatile and the recent four year stretch has proven to be no different. According to USDA’s Economic Research Service (ERS), national net farm income—a key indicator of U.S. farm well-being—is forecast at $62.3 billion in 2017, down nearly 9% from last year. The 2016 forecast represents the fourth consecutive year of decline from 2013’s record high of $123.7 billion and would be the lowest since 2002 in both nominal and inflation-adjusted dollars.
Now more than ever, it is important to understand what it takes to calculate profitability and to understand how to utilize the data to make decisions that will positively impact the overall operation. The BerganKDV agribusiness team recently completed the annual compilation of grain and farm supply industry benchmarking data. For more than 15 years, BerganKDV has provided comparison schedules for gross margins, operating revenues and expenses, and financial ratios to our clients. These benchmarks help clients assess the health of their organizations and how they stack up with industry averages.
To learn more about the benchmarking data or to better understand how to use financial performance measures to analyze your agribusiness operation, contact us.