Measuring Financial Performance: How Do I Measure It?

Measuring Financial Performance: How Do I Measure It?
Strategic Business Planning for Commercial Producers Measuring Performance Measuring Financial Performance: How Do I Measure It? This section of the course will help you understand the various aspects of financial performance and the measures used by finance professionals in making an assessment of financial performance. © Purdue University, Center for Food and Agricultural Business, 2002

Strategic Business Planning for Commercial Producers
Measuring Performance Objectives Introduce the measures of financial performance: Liquidity, Solvency, Profitability and Financial Efficiency Describe the calculations used Interpret the measures using benchmarks Topics discussed in this section includes some of the measures used by financial professionals to assess financial performance, the calculations associated with each of the measures, and the use of benchmarking to help interpret each of the measures. © Purdue University, Center for Food and Agricultural Business, 2002

Measures of Financial Position and Performance
Strategic Business Planning for Commercial Producers Measuring Performance Measures of Financial Position and Performance Profitability Liquidity Solvency Financial efficiency Repayment capacity Common measures of financial performance that the modern manager needs to be familiar with include liquidity, solvency, profitability, financial efficiency, and repayment capacity. While each is a different aspect of financial performance, they are related. The relationships that exist between these measures help suggest the type of action to take in order to make improvements in financial performance. We will discuss the first four areas in this section. Repayment capacity will be discussed in a later section. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Four Questions Are the returns adequate? How liquid is the business? How is the business financed? How efficient is the business? © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Benchmarking Comparing our business to those that are the best to learn how they achieve success Minimum performance is above average Financial benchmarks can come from past performance projected performance performance of similar farms Financial benchmarking uses the ratios that we have just calculated and attempts to answer the question of “How should my farm be doing if it is going to be competitive in the farming industry?” At the very minimum, your farm needs to perform better than average. More likely than not, an average level of performance will not be good enough long term. So, when establishing benchmarks for your farm it would be better to benchmark against the top-performing or so-called “high-profit” farms. It is also important to assess your current performance relative to performance in prior years. This can often lead to valuable insights into the trends in business performance. It is also important to monitor financial performance by projecting expected values for the key performance measures. While these projections do not tell the manager much about competitiveness, the projections can be used to systematically evaluate variations between planned performance and actual performance. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Benchmark data Farm business associations are good sources of benchmarks Illinois, Iowa, Kentucky, Tennessee and others Know your data source methods for summarization period in which data was collected calculations used for performance measures Benchmarks from farm business associations are almost always derived by averaging the actual performance data from a large group of farms. The high-profit benchmarks are typically derived by selecting the one-fourth or one-third of the farms in the group that are the most profitable and averaging the financial performance measures from those farms. Make an effort to know as much as possible about the source of the benchmarks against which you plan to measure your performance. The time period over which the data were gathered; methods used to summarize income, expenses, assets, and liabilities; and how the benchmarks are calculated are all important items to be explored before you rely on them. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Profitability Measures the extent to which a business generates a profit from the use of land, labor, management, and capital. Measured by Net farm income from operations (NFIFO) Rate of return on farm assets (ROA) Rate of return on farm equity (ROE) Operating profit margin (OPM) Net farm income from operations (NFIFO) is a absolute measure of profitability. While this makes it more difficult to interpret, it still serves as a basic measure of profitability. This measure is frequently the “bottom line” of an income statement and is used as the starting point for calculating the profitability measures of rate of return on farm assets and rate of return on farm equity. ROA , ROE, and OPM are technical efficiency measures of profitability. They compare the output produced, profits, to the inputs required to produce the output. This input measure for ROA is assets. The input measure for ROE is equity. While the input measure for OPM is gross revenue. Each of these measures will be discussed in more detail. © Purdue University, Center for Food and Agricultural Business, 2002

Net farm income from operations
Strategic Business Planning for Commercial Producers Measuring Performance Net farm income from operations Net revenues available from normal operations after fixed and variable expenses have been deducted For accuracy, calculate on an accrual basis For a sole proprietor farm operation, this income is available to compensate unpaid family labor, management, and equity capital Net farm income from operations does not include gains or losses from the sale of farm capital assets. These capital sales are not included in calculating profitability because the sale of farm capital assets occur infrequently and in many cases are not a part of the ongoing operation of the business. For greater accuracy, it is suggested that accrual adjustments be made to cash receipts and expenses. The accrual adjustments recognize changes in inventories, accounts receivable and other financial changes that affect revenue. The accrual adjustments also recognize changes in expenses such as accrued interest, accounts payable, and other items that affect expenses. The purpose of the accrual adjustments is to account for the financial transactions that took place during the accounting period even though no cash exchanged hands. Net income can also provide an indication for what is happening to the retained earnings of the business.If the farm is a sole proprietorship and net income is less than withdrawals for family living, retained earnings will decline. © Purdue University, Center for Food and Agricultural Business, 2002

Rate of return on assets
Strategic Business Planning for Commercial Producers Measuring Performance Rate of return on assets NFIFO + Interest expense – Unpaid labor compensation Ending Total Assets x 100 Net income generated by all assets, after labor has been compensated but before interest payments Operating profitability per dollar of assets Allows comparison between different sizes and types of businesses The rate of return on farm assets excludes interest expenses, interest is a financing expense not an operating expense. As a result of adding back interest expenses, this profitability measure provides an overall all efficiency measure for how well farm assets were used to produce net income from operations. Since this is a relative measure, it allows us to easily compare our farm to other farms. The rate of return on assets is probably the single best overall measure of operating performance. © Purdue University, Center for Food and Agricultural Business, 2002

Rate of return on equity
Strategic Business Planning for Commercial Producers Measuring Performance Rate of return on equity The return after all labor and interest expenses Measures the return to the owner of the business for their capital investment Can be compared to alternative investments 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. It also works just as well to the detriment of the farm business when debt is used unproductively. Managers need to know whether and to what extent financial leverage is working either for or against their farm business.ROE needs to 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. ROE is also a very useful measure of performance for the farm owner’s invested or equity capital. Farmers generally have other alternatives to investing in the farm operation and need a basis for comparing the likely performance of investments in the farm to their other alternatives. ROE provides this measure. However, remember that ROE is not a risk adjusted measure. When making comparisons among alternatives investment rates of return need to be adjusted for perceived riskiness of investment alternatives. © Purdue University, Center for Food and Agricultural Business, 2002

Operating Profit Margin
Strategic Business Planning for Commercial Producers Measuring Performance Operating Profit Margin Proportion of earnings or revenues that is operating profit Reflects ability to generate revenues and control costs Revenue available to compensate debt and equity capital A farm operation with a high operating profit margin is generally a low cost producer. If the operating profit margin is low the manger may respond by instituting cost controls. The manager could also respond by trying to increase revenues by producing higher value products. The OPM is one part of ROA. If OPM is multiplied by the asset turnover rate the result is ROA. This relationship indicates that one method to improve the ROA is to improve OPM. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Net Farm Income Gross Revenue $___________ Interest Expense - ___________ Other Expense - ___________ Net Farm Income $___________ For MBC Farms this is Gross revenue ($1,796,651) - Interest expense (-98,716) – Other expense (1,417,416) = Net farm income of $280,519. Note that these numbers can be found on Worksheet 1. Market value of assets is used for comparability. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Return to assets Net farm income $ ___________ Interest expense + ___________ Family living - Net return = Total assets  Return to assets _________ % For MBC Farms this is NFI (280,519) + Interest (98,716) - Family living (150,000) = Net return (229,235) / Total assets(4,655,476) = Return on assets of 4.9% © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Return to equity Net farm income $ ___________ Family living - ___________ Equity return = Total equity  Return to equity __________% NFI $280,519 - Family living (150,000) = Equity return (130,519) / Equity (3,534,037) = ROE of 3.7% © Purdue University, Center for Food and Agricultural Business, 2002

Operating Profit Margin
Strategic Business Planning for Commercial Producers Measuring Performance Operating Profit Margin Net farm income $ ___________ Interest expense + ___________ Family living - Net income = Gross Revenue  Operating profit margin _________ % NFI $280,519 + Interest (98,716) - Family living (150,000) = Net income (229,235) / Gross revenue (1,796,651) = Operating profit margin of 12.8%. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Profitability Scores Benchmark Measure Average High Profit Our Grade Net Farm Income Operating profit margin 16% 32% Return on assets 7% 14% Return on equity 6% 18% Our grade OPM = 12.8% ROA = 4.9% ROE = 3.7% These benchmarks are a four-year average from the Illinois Farm Business Farm Management (FBFM) program for grain farms over the years 1998 to The high profit farms are the top quartile. As we can see MBC Farms needs to improve its profitability. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Liquidity Ability of a farm business to meet financial obligations as they come due in the short term, without disrupting the normal operations of the business. Measured by Current ratio Two common measures of liquidity are the current ratio and working capital. The current ratio provides a relative measure, while working capital provides an absolute measure of liquidity. In order to make an assessment of liquidity using working capital, the size of the farm business needs to be taken into account. The larger the business, the more working capital required. However, the exact relationship between the amount of working capital and the size of the business is not well established. Since the current ratio is a relative measure where the amount of current assets are compared to the amount of current liabilities, this removes the influence that business size has on the measure. This makes ratios easier to compare and interpret than absolute measures. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Current ratio Current liabilities Current assets Basic indicator of short-term debt servicing and/or cash flow capacity. Indicates the extent to which current assets, when liquidated, will cover current obligations The calculation of the current ratio requires current asset and current liability data from the balance sheet. Current assets represent cash and those assets that will likely be turned into cash during the next year of business operation. These assets would include investments in growing crops, stored crops, market livestock that have not yet reached market weight, accounts receivable, and purchases of seed, fertilizer, and chemicals for next year’s crop. Current liabilities include those items that will need to be paid during the next year. These liabilities will include such things as an operating loan, accrued interest, accounts payable, and principal payments on term debt due in the next 12 months. For Midwestern farms, a current ratio less than 1.0 indicates difficulty in paying debts when they come due. This would correspond to negative working capital. For a balance sheet developed at the end of the year, many lenders like to see a current ratio of at least 2.0. But , remember that an acceptable current ratio will be influenced by the type of farm business and other factors. This measure does not take into account the timing associated with the receipt of revenue or the payment of expenses. Thus it is possible that the business could experience cash flow difficulties even with a strong liquidity measure. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Solvency Gauges the farm’s ability to pay all financial obligations if all assets are sold continue viable operations after financial adversity Measured by Debt to asset ratio Debt to equity ratio Equity to asset ratio Measures of solvency are concerned with the total value of farm assets and the total claims of others outside the business to those assets. Solvency measures strive to asses the ability to the business to with stand financial adversity. Bank loans and loans from others are always listed as liabilities on the farm balance sheet. However, few farm balance sheets will recognize contingent tax liabilities. This is a claim that we all know exists and is generally handled as a part of normal business operations. It also will occur only if we take an action that involves the sale of extra inventory or other farm assets. If we have large sales of inventories that have been built up over the years or if we cut our year-end purchases because we don’t have the cash, or we decide to sell the business, this claim can have a major impact. For completeness and to avoid unpleasant financial surprises, this liability needs to be recognized on the balance sheet and in assessing solvency. Solvency can be measured using the debt to asset ratio, the debt to equity ratio, or equity to asset ratio. All three of these ratios measure the same thing. We will focus on the debt-to-asset ratio. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Debt to asset ratio Total liabilities Total assets x 100 Proportion of total assets owned by creditors The debt to asset ratio is calculated by dividing the total farm debt by total farm assets. In making this calculation, assets are typically valued at market value. Lenders often us 40% as a breakpoint for the debt to asset ratio. Farms with debt to asset ratios less than 40% are often viewed as having the financial reserves needed to withstand the ups and downs that accompany farming. Those between 40% - 50% are viewed much more cautiously. For farms with debt to asset ratios more than 50%, others are contributing more to the financing of the business than the owners, a position that many lenders like to avoid. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Liquidity Score Current Ratio Current assets = $ Current liabilities ___________ Current assets ($485,376) / current liabilities ($321,867) = 1.51 © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Liquidity Scores Benchmark Measure Average High Profit Our Grade Current Ratio 3.1 3.3 MBC Farms has a current ratio of 1.51. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Solvency Score Debt-to-Assets Ratio: = $ % ___________ Total liabilities Total assets x 100 x 100 Total liabilities ($1,121,439) / total assets ((4,655,476) = 24.1% © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Solvency Scores Benchmark Measure Average High Profit Our Grade Debt to Asset 32% 26% MBC Farms has a debt to asset ratio of 24.1%. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Financial Efficiency Measures the intensity with which a business uses its assets to generate gross revenues and the effectiveness of production, purchasing, product pricing, financing decisions Financial efficiency measures the relation of inputs to outputs in financial terms. The financial efficiency measures presented here all contain a measure of output and a measure of input. Since these are efficiency measures they are expressed as dollar of output per dollar of input or dollar of input per dollar of output. © Purdue University, Center for Food and Agricultural Business, 2002

Financial Efficiency Measures
Strategic Business Planning for Commercial Producers Measuring Performance Financial Efficiency Measures Measured by Asset turnover ratio Operating expense ratio Depreciation expense ratio Interest expense ratio Net farm income ratio There are several measures of financial efficiency. Here, we will discuss 5 different financial efficiency measures in more detail. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Asset turnover ratio Total assets Gross revenue X 100 Reflects how efficiently farm assets generate revenue Indicates the volume of business generated by the asset base Our first measure of financial efficiency is the asset turnover ratio. In this case gross revenue is our output and total asset value is our input. The asset turnover ratio indicates how well we have been able to get assets to generate income. When you compare this measure from several farms you can find wide variation. Part of this variation can arise from the way that assets are controlled. If large amounts of farm land are rented rather than owned, this can influence this measure. The owned farm land will be part of the total assets that generate gross income. If the farmland is cash rented, land will not be included in the asset value even though the gross revenues will be the same as when land is owned. For some, this will provide an easy rational for why the farm may have a low asset turnover ratio. While the structure of asset control may be a contributing factor for a low asset turnover ratio, managers need to be sure that there are not other more important reasons. © Purdue University, Center for Food and Agricultural Business, 2002

Revenue per full-time laborer
Strategic Business Planning for Commercial Producers Measuring Performance Revenue per full-time laborer Number of full time laborers Gross revenue Reflects the productivity of labor Indicates if revenue generated is sufficient for full-time employment Our second measure of financial efficiency is revenue per full-time laborer. For this measure of efficiency, gross revenue is the output and the number of full-time laborers represents the input. In order to have adequate income for family living from farming, approximately $250,000 of gross revenue needs to be generated for each full-time person. If this measure is low, one might consider additional capital investments to increase the productivity of labor. An alternative would be to reduce the amount of time devoted to the farm by shifting some of the labor into nonfarm employment. © Purdue University, Center for Food and Agricultural Business, 2002

Operating expense ratio
Strategic Business Planning for Commercial Producers Measuring Performance Operating expense ratio Gross revenue Total operating expenses - depreciation X 100 Proportion of total revenues absorbed by operating expenses Our next measure of financial efficiency is the operating expense ratio. In this financial efficiency measure, gross revenue is the output measure and operating expenses are the input measure. This efficiency measure reports the amount of each dollar that is absorbed by operating expenses. In spite of being called the operating expense ratio we take out one of the expenses, depreciation. As a result, this ratio tells us how much of each dollar of gross revenue is paid out in operating expenses other tan depreciation. © Purdue University, Center for Food and Agricultural Business, 2002

Depreciation expense ratio
Strategic Business Planning for Commercial Producers Measuring Performance Depreciation expense ratio Gross revenue Depreciation expense X 100 Proportion of total revenues absorbed by depreciation The deprecation expense ratio is our next measure of financial efficiency. In this efficiency ratio, gross revenue is our output measure and deprecation is our input measure. This efficiency measure indicates how much of each dollar of gross revenue is spent on depreciation. © Purdue University, Center for Food and Agricultural Business, 2002

Interest expense ratio
Strategic Business Planning for Commercial Producers Measuring Performance Interest expense ratio Gross revenue Total farm interest X 100 Proportion of total revenues absorbed by interest expense For the interest expense ratio, output is measured as gross revenue and interest payments represent the input. This measure of efficiency measures how much of each dollar of gross revenue is spent for interest. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Net farm income ratio Gross revenue NFIFO X 100 Proportion of total revenue that remains as net income after all expenses have been paid Income that remains for unpaid labor compensation and equity capital The net farm income ratio is our last measure of financial efficiency. In this measure of efficiency, net farm income from operations or just net farm income is our measure of output. Gross revenue is our measure of input. This financial efficiency measure indicates how much of each dollar of revenue we are able to keep as profits. © Purdue University, Center for Food and Agricultural Business, 2002

Account for each dollar of gross revenue
Strategic Business Planning for Commercial Producers Measuring Performance Account for each dollar of gross revenue Operating expense ratio Depreciation expense ratio Interest expense ratio Net farm income ratio Sum to 1 Together these four measures of financial efficiency tell us where each dollar of gross revenue went. This also provides a check on our calculations. If these four ratios do not sum to 1, then there has been a mistake. © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Asset Turnover Ratio = $ ___________ Gross revenue Total assets x 100 GR (1,795,651) / total assets (4,655,476) = 38.6% © Purdue University, Center for Food and Agricultural Business, 2002

Financial Efficiency Scores
Strategic Business Planning for Commercial Producers Measuring Performance Financial Efficiency Scores Benchmark Measure Average High Profit Our Grade Asset Turnover Ratio 35% 43% Revenue per FTE ATR = 38.6% Revenue per FTE = 1,766,651 / 9 = $199,628 © Purdue University, Center for Food and Agricultural Business, 2002

Operating Expense Ratio
Strategic Business Planning for Commercial Producers Measuring Performance Operating Expense Ratio Other expenses $ ___________ Depreciation - ___________ Oper. expense = Gross revenue  Ratio _________ % Other expenses (1,417,416) - Depreciation (136,922) = Operating expense (129,627) / Gross revenue (1,796,651) = 71.3% © Purdue University, Center for Food and Agricultural Business, 2002

Where does the revenue go?
Strategic Business Planning for Commercial Producers Measuring Performance Where does the revenue go? Benchmark Measure Average High Profit Our Grade Operating Expense Ratio 63% 52% Depreciation expense ratio 8% 7% Interest expense ratio 6% Net farm income ratio 20% 37% Operating expense: 71.3% Depreciation expense: 7.6% Interest expense: 5.5% Net farm income ratio: 15.6% © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance Summary Key financial measures assess Profitability Liquidity Solvency Financial efficiency Calculations Interpretation We have reviewed several of the measures used for assessing profitability, liquidity, solvency, and financial efficiency. We have also investigated the calculations for each of these measures. Understanding the calculations is an important step in the interpretation of the measures that we have discussed. Interpreting the measures also involves comparing of our calculated measures to standards or benchmarks. These standards may be targets set by the management team or they can be industry measures based on data from farm business associations. More about the interpretation of our measures is presented in the section of the course entitled Financial Performance: How am I doing? © Purdue University, Center for Food and Agricultural Business, 2002

Measuring Performance 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 7-10), < Dobbins, Craig, Michael Boehlje, Alan Miller, Freddie Barnard, “Financial Performance: Measurement and Analysis”, Purdue Agricultural Economics Report, March 2000, pages Oltmans, Arnold W. Danny A. Klinefleter, and Thomas L. Frey, AFRA - Agricultural Financial Reporting and Analysis, Doane Agricultural Services Company, St. Louis, 1998. Miller, Alan, Michael Boehlje, Craig Dobbins, Key Financial Performance Measures for Farm General Managers, Department of Agricultural Economics, Purdue University, ID-243, June 2001. © Purdue University, Center for Food and Agricultural Business, 2002

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