Key Financial Performance Measures for Farm General Managers

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1 ID-243 Farm Business Management for the 21st Century Key Financial Performance Measures for Farm General Managers Purdue Extension West Lafayette, IN 47907

4 Worksheet 1. Computing Key Profitability Measures Operating Profit Margin A. Net Farm Income from Operations B. Estimated Value of Unpaid Operator Labor and Management C. Farm Interest Expense D. Return to Assets (A - B + C) E. Gross Farm Revenues F. Operating Profit Margin (D E x 100) Asset Turnover Ratio A. Gross Farm Revenues B. Average Total Farm Assets C. Asset Turnover Ratio (A B x 100) Return on Assets A. Net Farm Income from Operations B. Estimated Value of Unpaid Operator Labor and Management C. Farm Interest Expense D. Return to Assets (A - B + C) E. Average Total Farm Assets F. Return on Assets (D E x 100) % % % Return on Equity A. Net Farm Income from Operations B. Estimated Value of Unpaid Operator Labor and Management C. Return to Equity (A - B) D. Average Total Farm Equity (Farm Net Worth) E. Return on Equity (C D x 100) % 4

5 Return on Assets (ROA) General managers must make sure the capital they employ is used productively. Capital is relatively mobile. If it isn t used productively, it will eventually move on to where it can generate a competitive return. ROA provides a measure for assessing the overall efficiency with which farm assets are used to produce net income from operations. It also is indicative of management s effectiveness in deploying capital, because it is certainly possible to be efficient and yet poorly positioned in terms of how capital is being utilized. Return on assets, as an absolute dollar amount, is calculated as net farm income plus farm interest expense minus the estimated value of any unpaid operator labor and management used in the farming operation. That absolute dollar amount is converted to a rate of return on assets (ROA) by dividing by the average total value of farm assets. Return on assets is probably the single best overall measure of operating performance. It ties together the results of operations with the resources used to produce those results. It is also relatively easy to interpret. But what action should be taken to correct a poor return on assets? Everything the manager did both right and wrong in operating the business is reflected in the return on assets, which makes the appropriate corrective action difficult to determine without more information. The fact that financial measures are interrelated can help solve this dilemma. Operating Profit Margin (OPM) & Asset Turnover Ratio (ATR) The rate of return on assets measure is itself the product of a measure of financial efficiency and a measure of profitability. The rate of return on assets may be calculated by multiplying the operating profit margin ratio (OPM) times the asset turnover ratio (ATR). The interrelatedness of these three performance measures emphasizes the fact that there are two primary ways to enhance the efficient use of farm resources to produce profit. One is to increase the profit per unit of output. Operating profit margin is a measure of profit per unit (dollar) of product produced or output. It is calculated by dividing the dollar amount of return on assets by gross farm revenues. A farm operation that has a high operating profit margin percentage is a low cost producer. Thus, the general manager may respond to a poor or small operating profit margin by instituting cost controls in order to increase profits per unit. The other way to enhance performance is to increase the revenues generated per dollar of farm assets, as indicated by the asset turnover rate. For example, more higher value crops might be added to the crop mix to effect an increase in asset turnover. ATR is calculated by dividing gross farm revenues by the average value of total farm assets. For a given set of farm resources or size of farm, operating profit margin and asset turnover are the two key determinants of profit that the general manager must try to influence in order to improve financial performance. An increase in either or both will increase ROA and is generally indicative of improved financial performance. Return on Equity (ROE) Debt is an important component of the capital structure of many farm businesses. Debt provides needed resources to take advantage of profit opportunities. When used productively, debt can leverage equity capital in a way that is very beneficial financially. But financial leverage is impartial and unforgiving. Debt works just as well to the detriment of a farm business when it is used unproductively, as it works to benefit a farm that is managed wisely. General managers need to know whether and to what extent financial leverage is working either for or against their farm business. The rate of return on equity (ROE) provides useful information about the performance of debt in the capital structure. ROE is calculated by dividing net farm income minus the estimated value of any unpaid operator labor and management by average total farm equity (net worth). ROE should exceed ROA for farms that borrow money. If ROE doesn t exceed ROA, it means that borrowed capital isn t earning enough to pay its cost. Alternatively, ROE may be well above ROA and may indicate potential to benefit from additional investments in the farm. 5

7 The farm business manager s objective is to stay at or above the economic break-even volume. As total quantity produced increases, total revenues increase, as do variable costs. Because revenue per unit is greater than variable costs per unit, total revenue increases at a faster rate than variable costs with increases in volume or quantity produced. At some level of quantity produced, which is called the break-even volume, total revenues will equal total costs. A volume of business that is greater than the breakeven point will result in profits for the farm firm. As the quantity of output from the farm, as indicated by gross farm revenues, increases, the likelihood of breaking even improves because fixed costs decline on a per unit basis. A greater difference between per unit revenues and per unit variable costs reduces the volume required to break even. Total Revenues Profit/Loss Corridor Cost or Revenue () Total Cost Fixed Cost Variable Costs Fixed Cost BE Quantity Capacity Quantity Produced Figure 1. A Break-Even Diagram Figuring the break-even economic volume for a farm business is not a particularly easy task. It is complicated by the difficulty in distinguishing between fixed and variable costs. Some costs, such as machinery repair and maintenance costs, are actually semi-variable costs. That is, part of the repair costs will vary with the quantity produced on the farm, and part of the repair costs will occur regardless of the quantity of production. It is further complicated by the need to impute (estimate) the costs of unpaid labor and management and owner s equity capital. Generally, these particular imputed costs are classified as fixed costs. Size, Efficiency, & Spendable Income One method of determining whether business volume is sufficient is to do an income needs analysis. The purpose of this analysis is to determine the size of business needed to generate a level of income that will satisfy the farm family s needs. This kind of analysis is similar to repayment capacity analysis. But, generally, more net income is required with the needs analysis than with a repayment capacity analysis. This is because depreciation expense is not added back to net income when determining how much money is available to satisfy needs. Worksheet 2 is designed to help producers work through their own needs analysis. 7

8 Let s consider an example of how to use Worksheet 2. Sam Smith s needs for income are first estimated and then used to evaluate the sufficiency of farm revenues. Sam Smith has estimated the following needs: Family living expenses = 39,000, Annual term debt principal payments = 30,000, Annual average income and self-employment tax payments for Sam and his wife = 12,000, Annual planned new investment in the farm = 20,000, Annual additions to savings for children s education = 5,000. Thus, Sam Smith s estimated annual income needs total 106,000. He can count on 36,000 of net non-farm income to help provide for these needs. The balance of 70,000 must come from net farm income generated by the farm business. Over the past four years the farm has generated an average of 67,000 of net farm income from 335,000 of gross farm revenues. So net farm income has normally been about 20 percent of gross farm revenues. If we divide the 70,000 of estimated needs that the farm must provide by the net farm income ratio of 20 percent, we find that the farm needs to generate 350,000 of average annual gross revenues in order to generate the 70,000 of income needed. Sam has the farm producing nearly enough revenue to meet all of his estimated needs. He may have opportunities for increasing gross farm revenues. He might also consider ways to increase the net farm income for the farm, so that more of the farm revenue will be available to meet his expected needs. A farm business manager s income needs will almost certainly increase over time, if for no other reason than inflation in the cost of living and the cost of doing business. With that in mind, farm business managers need to plan for and monitor growth in sales (revenues), so that earnings will have the potential to grow over time. It will also be important to monitor earnings growth in order to ensure that sales growth is having the desired effect on earnings. 8

9 Worksheet 2. Income Needs Analysis Part I. What Level of Annual Spendable Income Do You Want/Need? Estimated/Expected Needs or Wants: A. Family Living Expense B. Debt Service (principal due on term debts) C. Carryover Debts (principal due on carryover operating debt) D. Income and Self-Employment Social Security Taxes E. New Investments in the Farm Business F. Savings for Children s Education G. Retirement Contributions H. Family Living Capital Expenses I. Other Wants and Needs J. Total Need for Income (sum A through I) Estimated/Expected Amount the Farm Must Provide: K. Expected Net Non-Farm Income Available to Meet Needs L. Desired Spendable Income (J - K) (Proceed to Part II) Part II. Gross Revenues Required to Produce Desired Spendable Income (L) Based on Actual Past Performance (The two measures in italics should be based on your farm records for a typical year or for an average of recent previous years.) M. Normal Ratio of Net Farm Income from Operations to Gross Farm Revenues for Your Farm (Net Farm Income Gross Farm Revenues ) = N. Gross Farm Revenues Required to Generate Needed Spendable Income (Amount from L Answer from M ) = 9

11 Once asset turnover has been increased as much as possible, then farm business managers should focus on actions that will reduce cost without a corresponding decrease in revenue. One useful strategy involves targeting costs to come in under a predetermined percentage of revenues so as to result in an acceptable operating profit margin. Once asset turnover and operating profit margin have been pushed to their upper limits, the farm business manager should look at expanding the total volume of business. If asset turnover has really been pushed to the maximum, then the decision to expand will likely require additional capacity to produce, which may require additional investment. But farm business managers should not even consider this alternative until all of the potential to increase volume through more efficient use of existing resources has been exploited. Acceptable Operating Profit Margin Acceptable If both asset turnover and operating profit are at acceptable levels, then increase size. Needs Improvement ASSET TURNOVER Needs Improvement Look for ways to increase the revenues generated from existing assets. Re-evaluate: Thruput Crop Mix/Product Mix Marketing Program Yields Resource Use Custom Work Enterprise Look for non-performing/underperforming assets to cull. Re-evaluate: Leasing versus Owning Assets Custom Work versus Owning Underutilized Machinery Sharing Assets (Partnering) Look at cost controls. Look for ways to decrease expenses without reducing revenues. Re-evaluate: Production Costs Rents Capital Spending Plans Purchasing Practices Family Needs Business Organization Financing Costs Employment Inventory Management Outsourcing Records Control Procedures Management s Priorities Figure 2. Flowchart for Assessing and Improving Farm Firm Profitability 11

15 Worksheet 1. Computing Key Profitability Measures Operating Profit Margin A. Net Farm Income from Operations B. Estimated Value of Unpaid Operator Labor and Management C. Farm Interest Expense D. Return to Assets (A - B + C) E. Gross Farm Revenues F. Operating Profit Margin (D E x 100) % Asset Turnover Ratio A. Gross Farm Revenues B. Average Total Farm Assets C. Asset Turnover Ratio (A B x 100) % Return on Assets A. Net Farm Income from Operations B. Estimated Value of Unpaid Operator Labor and Management C. Farm Interest Expense D. Return to Assets (A - B + C) E. Average Total Farm Assets F. Return on Assets (D E x 100) % Return on Equity A. Net Farm Income from Operations B. Estimated Value of Unpaid Operator Labor and Management C. Return to Equity (A - B) D. Average Total Farm Equity (Farm Net Worth) E. Return on Equity (C D x 100) % 15

16 Worksheet 2. Income Needs Analysis Part I. What Level of Annual Spendable Income Do You Want/Need? Estimated/Expected Needs or Wants: A. Family Living Expense B. Debt Service (principal due on term debts) C. Carryover Debts (principal due on carryover operating debt) D. Income and Self-Employment Social Security Taxes E. New Investments in the Farm Business F. Savings for Children s Education G. Retirement Contributions H. Family Living Capital Expenses I. Other Wants and Needs J. Total Need for Income (sum A through I) Estimated/Expected Amount the Farm Must Provide: K. Expected Net Non-Farm Income Available to Meet Needs L. Desired Spendable Income (J - K) (Proceed to Part II) Part II. Gross Revenues Required to Produce Desired Spendable Income (L) Based on Actual Past Performance (The two measures in italics should be based on your farm records for a typical year or for an average of recent previous years.) M. Normal Ratio of Net Farm Income from Operations to Gross Farm Revenues for Your Farm (Net Farm Income Gross Farm Revenues ) = N. Gross Farm Revenues Required to Generate Needed Spendable Income (Amount from L Answer from M ) = 17

17 Worksheet 3. Computing Sustainable Growth Rate Sustainable Growth Rate A. Net Farm Income from Operations (NFIFO) B. Owner Withdrawals for Family Living Expenses C. Other Owner Withdrawals D. NFIFO Retained by the Farm Business (A - B - C) E. Average Total Cost Basis Equity F. Sustainable Growth Rate (A B x 100) % Click here for printable copies of all three worksheets. 19

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