Improving Financial Performance: What Is the Payoff?

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Improving Financial Performance: What Is the Payoff?

Objectives Understanding determinates of operating performance (ROA) Understanding determinates of financial performance (ROE) Links between managerial decisions and financial performance

Determinants of Operating Performance (ROA) Operating profit margin Asset turnover ratio Operating Profit Margin Turnover Ratio Return on Assets X=

Determinants of Financial Performance (ROE) Operating profit margin Asset turnover ratio Leverage Return on Assets Interest Assets LeverageROE -X=

Profitability Analysis AKA The DuPont Model

DuPont Analysis Operating Performance Gross Revenue Fixed Costs Variable Costs Net Income -- = Total Assets Gross Revenue Turnover Ratio = ÷ ROA x Interest Expense Net Income Gross Revenue Operating Profit Margin +÷= Total AssetsEquity Financial Structure = Financial Structure ÷ ROE Interest Assets - x

Implications If ROE > ROA – Interest rate less than ROA – Making money on borrowed money – Increase ROE by borrowing more (but be careful)

Implications If ROE < ROA – ROA less than interest rate – Losing money on borrowed money – Reduce interest cost – Reduce debt – Improve operating performance (ROA)

Improving performance Ways to enhance operating performance (ROA) – Increase operating profit margin – Increase volume per dollar invested or capital turnover Ways to enhance equity return (ROE) – Enhance operating performance – Reduce financing costs – Leverage – more debt

Data for Profit Analysis 1.Gross Revenue 2.Fixed Costs 3.Variable Costs 4.Interest Costs 5.Total Assets 6.Equity Income Statement Balance Sheet

Example Case: MBC Farms Operated by Mike, Betty, and Craig Enterprises – Crops, dairy Operate 3,000 acres, 250 milking cows – Own 1,800 acres, cash rent remainder Six full-time employees

Worksheet 1: Cost Basis Inputs

Worksheet 4 Spreadsheet for MBC Farms Case

Worksheet 4: MBC Farms (cost value) Financial Data 1. Gross Revenue\$1,796,651 2. Fixed Costs385,638 3. Variable Costs1,280,494 4. Net Income130,519 5. Total Farm Assets2,408,799 6. Owner's Equity1,287,360 7. Interest Expense98,716

Complete Worksheet 4

Worksheet 4: MBC Farms (cost value) Operating Profit Margin12.8% Asset Turnover Ratio74.6% Return on Assets 9.5% Interest Cost of Assets 0.041 Financial Structure 1.87 Return on Equity 10.1%

Worksheet 4: MBC Farms (market value) Operating Profit Margin12.8% Asset Turnover Ratio38.6% Return on Assets 4.9% Interest Cost of Assets 0.021 Financial Structure 1.32 Return on Equity3.7%

Reduced interest Opportunity to refinance term debt at a 1% lower interest rate \$91,648 in intermediate debt and \$799,573 term Saves about \$8,913

Complete Alternative on Worksheet 4

Reduced Interest ActualProjected 1. Gross Revenue\$1,796,651 2. Fixed Costs385,638376,725 3. Variable Costs1,280,494 4. Net Income130,519139,432 5. Total Farm Assets2,408,799 6. Owner's Equity1,287,360 7. Interest Expense98,71689,803

Reduced Interest Results ActualProjecte d Operating Profit Margin12.8% Asset Turnover Ratio74.6% Return on Assets 9.5% Interest Cost of Assets 0.0410.037 Financial Structure 1.87 Return on Equity 10.110.8%

Earlier soybean planting Has been planting about half of soybeans after June 23 Pushing harder would result in about a 10% increase in soybean revenue No change in costs

Earlier Planting ActualProjected 1. Gross Revenue\$1,796,651\$1,832,087 2. Fixed Costs385,638 3. Variable Costs1,280,494 4. Net Income130,519165,956 5. Total Farm Assets2,408,799 6. Owner's Equity1,287,360 7. Interest Expense98,716

Earlier Planting Results ActualProjected Operating Profit Margin 12.8%14.4% Asset Turnover Ratio 74.6%76.1% Return on Assets 9.5%11.0% Interest Cost of Assets 0.041 Financial Structure 1.87 Return on Equity 10.112.9%

Summary Measurement of performance – Operating: ROA – Financial: ROE Determinants of rates of return – Operating profit margin – Asset turnover ratio – Cost of debt – Leverage Links among managerial decisions & rates of return

Key Points? What are the 2 key elements of operating performance? Overall financial performance is measured by what ratio? With respect to financial performance, when is debt a good thing?

References Boehlje, Michael, Craig Dobbins, Alan Miller, Dawn Miller, & Freddie Barnard, Measuring and Analyzing Farm Financial Performance, Department of Agricultural Economics, Purdue University, EC-712, 1999 (pages 37-43), Miller, Alan, Michael Boehlje, and Craig Dobbins, Key Financial Performance Measures for Farm General Managers, Department of Agricultural Economics, Purdue University, ID-243, June 2001.

Strategic Business Planning for Commercial Producers

Worksheet 4 Financial Data MBC Farms 1. Gross Revenue 2. Fixed Costs 3. Variable Costs 4. Net Income 5. Total Farm Assets 6. Owner's Equity 7. Interest Expense

Reduced Interest Results ActualProjecte d Operating Profit Margin 12.8% Asset Turnover Ratio 74.6% Return on Assets 9.5% Interest Cost of Assets 0.041 Financial Structure 1.87 Return on Equity 10.1

Earlier Planting Results ActualProjected Operating Profit Margin 12.8% Asset Turnover Ratio 74.6% Return on Assets 9.5% Interest Cost of Assets 0.041 Financial Structure 1.87 Return on Equity 10.1