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How financially healthy is your farm?

AME Management: These two examples show how standardized financial statements can be a powerful source of insight into your operational management

Three articles in this space over the last year (see links further down) focused on the management information to be obtained from standardized farm accounting statements. This month, we illustrate it here with two farm examples, concentrating on the operating (profit and loss) statement.

The organization of our operating statements is based on three principles:

  1. Revenue should be only from farming operations. Crop insurance payments count, but other government payments and revenue generated from non-farming activities go at the end under “Other Income.”
  2. Managing operations is different than managing capital, so the costs of each should be evaluated separately. We regard leasing or rental costs as costs of capital and include them with depreciation/amortization and interest.
  3. All farm operations have three categories of cost:
    – Raw and intermediate products that are converted into final products: seed, fertilizer, feed, chemicals, medicines (and crop insurance premiums). These are Cost of Goods Sold (COGS).
    – Direct operating costs (DOC) of machinery and equipment, transportation, and operating labour.
    – Operating overheads (OH), including management and office salaries, general utilities, banking charges, professional fees, and property taxes.

Our CTEAM participants often express frustration that they don’t understand how well they are doing. Their accounting statements focus on taxes, no two statements are alike, and/or they focus on government programs, not on information to help evaluate or improve their management.

The tables shown further down for Farm A and Farm B contain actual formats for two farms (the numbers are not from any actual farm). The first column summarizes the operating statements each received, and illustrates the problem.

In Farm A’s operating statement, costs are organized into seed and seedlings, allowable and non-allowable expenses. The latter two reflect definitions in government programs but have nothing to do with management. This format also doesn’t separate capital and operations, and bears no resemblance to the cost categories above. Also, the farm owner has an agricultural business in addition to the farm that is included with farm revenue.

On the surface, it would appear that Farm A is relatively profitable with Earnings before Taxes (EBT) of $600,000 on sales of $3.4 million.

Farm B’s operating statement is closer in line with the principles outlined above: “Other Expenses” toward the end is essentially amortization and interest i.e. capital expense. Farm B seems less profitable with EBT of only $200,000 on sales of $3.2 million.

The second column has the two farms’ data rearranged in our standardized format.

Farm A

The non-farm income, as well as some government payments, are taken off the top line with its business costs, and the net is in the “Other” category. So “Sales” represent revenue ($2.7 mil.) of the farming operation. Deducting COGS (seed, fertilizer and chemicals) gives Gross Margin of $1.7 mil. Top farms expect gross margin of at least 65 per cent of sales, therefore COGS should be under 35 per cent. At 63 per cent and 37 per cent, Farm A has problems with some or all of: yields are not high enough; selling prices are too low; or crop inputs cost too much.

farm-a

Direct Operating Costs for Farm A are 26 per cent of sales, again higher than the benchmark of 15-20 per cent. Subtracting DOC from Gross Margin gives Contribution Margin of $37 per cent, under the 45-50 per cent we would normally expect. This suggests that machinery and/or labour costs are also too high.

Overhead costs are 11 per cent of sales, within the 10-15 per cent benchmark. Subtracting Overheads from the Contribution Margin gives Earnings before Interest, Taxes, Depreciation/Amortization (EBITDA), which should be 35 per cent or more of sales. Farm A’s 26 per cent is well below top farms. Farm A’s operations generate $700,000 on sales of $2.7 mil. At 35 per cent, it would generate almost another $250,000.

Space doesn’t allow showing the balance sheet, but A has a lot of debt: interest is $200,000 while depreciation and rental payments are $700,000, leaving a negative net contribution from the farming operation. A’s side business, government payments and other investments provide the profits.

The Current and Debt/EBITDA ratios show A’s financial tightness. At 1.2, the current ratio is less than the normal 1.5-2.0 range, meaning current assets barely cover current obligations. Debt/EBITDA means that if A used operating earnings from the farm to pay nothing but loan principal, (no interest, taxes, new investment, land or machinery rental, or owners), nothing else could be paid or purchased for 8.13 years. This is a highly leveraged position. Adding $250,000 to EBITDA would bring these ratios to 1.5 for current, and 4.8 for Debt/EBITDA.

Farm B

Farm B’s financials required less adjustment to get to the standardized statement. A small amount of government payments went to “Other Income.” Seed, fertilizer, chemicals and crop insurance payments were aggregated into COGS, resulting in costs of 29 per cent of sales and Gross Margin of 71 per cent, well above the 65 per cent benchmark.

farm-b

Direct Operating Costs at just under 25 per cent are above the benchmark range and Overheads at 13 per cent are in the range. Farm B needs to concentrate on reducing some combination of machinery operating or labour expense.

At 35 per cent, Operating Efficiency is at the standard. Focus on Direct Expenses would improve it further.

Farm B has an interesting balance sheet. It has only a little bank debt. The remainder is family debt for which no interest is required. However, it rents a large portion of its land and a little of its machinery, to the tune of $900,000 annually. This cost sticks out like a sore thumb, taking up most of its operating income. Management needs to reduce this cost.

Because of the healthy operating earnings and the structure of the balance sheet, both the Current and Debt/EBITDA ratios are very healthy, suggesting one potential way to reduce the rental cost is to consider a larger ownership position.

Conclusion

These two examples show the management information that can be gleaned from standardized financial statements from which benchmarks can be gleaned. In their raw form, the examples provided little of value, but the standardized format allows the identification both of issues, and what needs focus.

Farm A has problems with both operational management: too little revenue is generated from the expenses on plant material and direct operating costs, probably because of too much labour cost. On its own the farm faces restricted strategic options because of its low returns relative to debt.

Farm B has relatively good operational management, but needs to improve capital management and reduce its direct operating expenses. Its balance sheet provides flexibility to deal with this.

Those who use this approach quickly see its value in evaluating and making better management decisions.

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