Farm Business Analysis—Ch.18 What are the strengths and weaknesses of the farm business? How can we measure how well the farm is doing?

Which farm would you prefer? Farm A Net worth $400,000 Operator Labor12 mo. Net income $50,000 Farm B Net worth $800,000 Operator Labor24 mo. Net income $80,000

What Affects Net Farm Income and Cash Flow? Size Efficiency

Size or Scale of the Farm Resources Acres Cows or sows No.of layers Total assets--$ Number of workers Production Pigs sold Cattle fed out Bushels sold Lbs. of milk Gross sales--$

Efficiency = production per unit of resources Physical efficiency bushels per acre lbs. milk per cow pigs per sow per year lambs per ewe pounds of feed per lb. of gain

Economic Efficiency (value of product per unit of resource) Crop value per acre--$ Asset turnover ratio--% = gross income / total assets Livestock returns per $ of feed Gross income per person (FTE)

Economic efficiency also depends on: Value of Product (marketing) Sale price Quality Time Place Cost of Resources Seed, chemicals Cash rent Machinery, fuel Wages Feed

Economic Efficiency = Units of output x selling price Units of resource x purch. price Ex.: livestock production per $ feed 1 lb. gain x $.50/lb. price = $ lb. feed x $.08/lb. cost = $.24 = $2.08 per $ feed fed

1 lb. gain x $.50/lb. price = $ lb. feed x $.08/lb. cost = $.32 = $1.56 per $ feed fed 1 lb. gain x $.40/lb. price = $ lb. feed x $.12/lb. cost = $.36 = $1.11 per $ feed fed

Economic Efficiency Depends on: Physical efficiency Selling price (marketing) Cost of resources

Standards of Comparison Budgets Historical records for the same farm Current records from comparable farms

Financial Analysis Solvency Liquidity Profitability

SOLVENCY: Comparing assets to liabilities Net worth - $ Debt-to-asset ratio (or other ratio) Debt-to-asset ratios of 30 % to 40 % are typical, though many farms have no debt.

Leverage: degree in debt Total debt-to-asset ratio low averagehigh High leverage means the farm net worth will grow faster when margins are high and lose equity faster when margins are low.

Liquidity (having cash when needed ) Current ratio = current assets current liabilities Working capital = (current assets - current liabilities)

LIQUIDITY Current ratio should be 2.0 or better Farms with continuous sales can have 1.5, but farms with infrequent sales may need 3.0 Working capital typically equals 25 % to 35 % of total expenses (annual)

Profitability - $ (income and expenses) Net farm income value of unpaid labor ($/year) interest on owner equity (% interest rate x net worth) = Return to management These are opportunity costs

Net Farm Income also depends on how many of your resources you contribute yourself. Operator labor instead of hired labor. Net worth capital instead of debt. Owned land instead of rented. Net Farm Income is a return to operator labor, net worth and management.

Example Net farm income - value of unpaid labor (15 $3,000) - value of owner equity ($600,000 net 4%) = Return to management $80,000 $45,000 $24,000 $11,000

Profitability--% Return on Equity (ROE)--% = (NFI – unpaid labor) / farm net worth Example: ($80,000 - $45,000) / $600,000 = $30,000 / $600,000 = 5.0 %

Profitability--% Return on debt capital (interest) = Interest paid for the year / total liabilities Example:interest expense = $28,000 liabilities = $400,000 Average interest rate = 7.0%

Return on Assets (ROA) ROA is the combined return on equity and debt capital = (NFI – unpaid labor + interest expense) (net worth + liabilities) or total assets = ($80,000 - $45,000 + $28,000) ($600,000 + $400,000) = $63,000 / $1,000,000 = 6.3 %

Return on assets (ROA) is an average of the ROE and interest rate Example: farm capital is 60% equity and 40% debt ROE = 5 % Interest rate = 7% ROA = (.60 x 5%) + (.40 x 7%) = 6.3 %

PROFITABILITY Return on assets (ROA) low averagegood

Other ratios Gross revenue can be divided into: operating expense (60 to 70 %) depreciation (5 to 10 %) interest (5 to 10 %) net farm income (15 to 20 %) High profit farms may keep 25 to 30 % of their gross revenue as net income

FINANCIAL PERFORMANCE MEASURES 1. Compare to similar farms. 2. Look at trends over several years. 3. Supplement ratios with production data and enterprise analysis.