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Use financial ratios to diagnose operational issues

AME Management: Different farms have different factors affecting their performance

The profit and loss statement provides three financial ratios that can help identify operational issues and set priorities in your operations plan.

The ratios and their benchmarks are:

revenue-earnings

The first and third columns define revenue/earnings and cost categories deducted from them on a standardized operating statement. The second and fourth are the resulting operating and cost ratios and their benchmarks. Cost of goods sold should be 35 per cent of revenue for cash crop and some livestock farms. CoGs is essentially seed, chemicals and fertilizer for crops, and feed, vet and medicine for livestock. Deducting CoGs from Revenue gives Gross Margin, 65 per cent of sales (by definition).

Next, subtract Other Operating Costs (OC) from Gross Margin. OC includes hired labour, custom work, and machinery operating costs (fuel, lube, repairs and maintenance). For crop and most livestock farms, these should be 15 to 20 per cent of total revenue. The resulting contribution margin, by definition, is 45 to 50 per cent of sales.

Finally, subtracting off Operating Overheads gives Earnings before Interest, Taxes and Depreciation/Amortization. Overheads are normally in the 10 to 15 per cent range. They include hydro, management salaries, insurance, rents, legal and accounting expenses, property taxes. So, by definition, total operating efficiency — i.e. operating earnings/revenue, should be around 35 per cent.

These ratios are attained by many of the cash crop and livestock farms in CTEAM. Expect higher gross margins, but also higher operating cost ratios for horticulture. Operating ratios will be lower for feedlots because of their proportion of purchased inputs.

Using the ratios to diagnose and evaluate your operating statement

Your ratios and the standards provide a lot of information about your operational effectiveness. To illustrate, three example farms’ ratios are below: (it’s best to use three to five years of data to get an accurate picture of what’s happening).

gross-margins

I start with operating efficiency: it signals the overall health of the business because it’s how much is left of each dollar of sales after paying all costs except depreciation, interest and taxes. OE is 26 per cent for all three, above average but below the benchmark.

Yet each of the three show very different characteristics.

Farm 1 exceeds the 65 per cent benchmark for gross margin and is under 15 per cent for operating overheads. Farm 1’s problem is that its other operating costs are 31 per cent of revenue while 15 to 20 per cent is expected. High OCs may indicate excess labour that needs to be used more effectively. Alternatively, machinery operating costs may be high because of age of equipment and/or too much for the farm. Another possibility is small equipment is being purchased that is not employed well or should be included in capital costs and depreciated. Often the best approach is to examine the largest individual costs in this category and focus on reducing them or find ways to employ them more effectively.

Farm 2 has good cost control since other operating and overhead costs are 18 per cent and 13 per cent of revenue, well within the target ranges, but CoGs is 43 per cent. This likely means Farm 2 has problems with some combination of product selling prices, low yields or ineffective control of direct production costs.

Farm 3 has CoGs and OC of 31 per cent and 13 per cent, but overheads are 26 per cent of revenue. This problem often stems from high rental prices for land or from an operation that is overpaying for management labour.

Summary

The examples illustrate the variety of situations that can exist: different farms have different factors affecting their performance. Financial results in this standardized format show whether poor performance is simply a result of bad markets or management factors that can be corrected. They also illustrate that identifying the problem is the first step in setting priorities to make improvements in operations. Farm 1 is going to focus on labour and machinery costs. Farm 2 will prioritize production and marketing. Farm 3 will likely try to do something about rental rates or management costs.

Of course, effort has to be maintained on aspects that are doing well, but this approach can be helpful in prioritizing management efforts.

Larry Martin is a principal of Agri-Food Management Excellence and is one of the instructors in AME’s Canadian Total Excellence in Agriculture Management program.

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