farm business analysis—ch.18 what are the strengths and weaknesses of the farm business? how can...

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 Labor 12

mo. Net income $50,000

Farm B Net worth $800,000 Operator Labor 24

mo. Net income $80,000

What Affects Net Farm Income and Cash Flow?

SizeEfficiency

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 efficiencybushels per acrelbs. milk per cowpigs per sow per yearlambs per ewepounds 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 assetsLivestock returns per $ of feed Gross income per person (FTE)

Economic efficiency also depends on:

Value of Product (marketing)

Sale priceQuality TimePlace

Cost of ResourcesSeed, chemicalsCash rentMachinery, fuelWagesFeed

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 efficiencySelling price (marketing)Cost of resources

Standards of Comparison

BudgetsHistorical records for the same

farmCurrent records from comparable

farms

Financial Analysis

SolvencyLiquidityProfitability

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 average high

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

liabilitiesWorking capital =

(current assets - current liabilities)

LIQUIDITYCurrent 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 managementThese 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 =

$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)

<---0%-------4%--------8%--------12%--->

low average good

Return on Assets for Iowa Farms

8% 7%6%

-2%

2%

6%

2%5% 5% 5%

8%

15%

6%

-10%

-5%

0%

5%

10%

15%

20%ROAROE

Return on Assets for Iowa FarmsHigh Third Average, Low Third Average

-12%-10%

-8%-6%-4%-2%0%2%4%6%8%

10%12%14%16%18%20%

%

Other ratiosGross 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.