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 = $.50

3.0 lb. feed x $.08/lb. cost = $.24

= $2.08 per $ feed fed

1 lb. gain x $.50/lb. price = $.50

4.0 lb. feed x $.08/lb. cost = $.32

= $1.56 per $ feed fed

1 lb. gain x $.40/lb. price = $.40

3.0 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

<---10%------20%------40%------60%-->

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 months @ $3,000)

-value of owner equity

($600,000 net worth @ 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 =

$35,000 / $600,000 = 5.8 %

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 5.8%) + (.40 x 7.0%) = 6.3 %

PROFITABILITY

Return on assets (ROA)

<---0%------4%------8%------12%--->

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

Compare to similar farms.

Look at trends over several years.

Supplement ratios with production data and enterprise analysis.