How healthy is your farm? Check these vital stats to really know — not just guess — your farm’s fitness level
When your doctor puts you through a battery of tests, you learn exactly how much heavy lifting it’s smart to do.
Otherwise, that bit of pain you think you felt last week might keep you in the house. Or you might ignore the pain as a fluke, and end your day in the back of an ambulance, or worse.
It’s the same with putting your farm through a series of simple health tests. The point isn’t to find out how sick you might be (although that’s important too), it’s also to find out how strong you are.
Read Also
Riding the tariff rollercoaster
Farmers are accustomed to roller-coaster years. But the current geopolitical windstorm is something else entirely. On his cattle operation near…
Should you buy the farm down the road, despite the price? Can you make room for your son or daughter to come back to the farm with their family?
Equally important, are you getting the right advice?
“Farmers need to know their numbers well enough to sense when they can push back,” says Harold Froese, a Manitoba egg farmer who is also a loans agent for Sanford Credit Union. “The banks don’t always have a consistent message.”
Of course, it’s vital to see the red flags too. It isn’t good enough to let your lender calculate ratios and tell you if something is wrong, says Froese. “Over my 35 or so years, I’ve had to sit across the table from families who have lost their farms simply because of timing decisions.”
It turns out you don’t need to be a bean counter to get to the vital take-homes, says Jonathan Small, farm management consultant with MNP out of Red Deer, Alta. By knowing a few definitions and where to find the important stuff, you can ask and answer some pretty earth-shattering questions.
So blow the dust off that stack of balance sheets and income statements. What are your numbers telling you?
1. Profits:So if profit isn’t just what’s left in the bank at the end of the year, then what is it?
Every business should generate profit over time, including farms. It’s standard business theory. If net income isn’t positive for an extended period, it’s time to assess your business model and look for opportunities to either increase revenues or to reduce expenses, or to do both.
Or maybe it’s time to move your assets somewhere else where they will be productive.
On the farm, however, profit isn’t always so easy to define. At the very least, it’s more difficult than for your relatives in the city who can simply add up all their pay stubs.
Instead of a drawback, however, the fact that profit on the farm can be measured a multitude of ways can actually generate additional insights into the health of your operation.
Start by comparing your net farm income to previous years. This will tell you if the trend is going in the right direction, and it will also give you a preliminary assessment as to whether the business is meeting your needs and goals.
It’s easy to find your net income numbers. Net income (or loss) for the year is given on the bottom of the statement of operations, which is also sometimes called your income or profit and loss statement.
If you’re looking at a statement generated with cash accounting versus accrual, be forewarned that net farm income can be misleading since it won’t take into consideration inventory, pre-payables, receivables or payables. “Looking at cash reporting can lead farmers down a blind alley as to whether your farm is functioning well or not,” warns Small.
When looking at net farm income, Froese also considers how the farm is managing depreciation and inventory.
Even within an accrual system, however, looking at net farm income can only take you so far. One problem is that it doesn’t relate the income to the size of the investment. Nor does it take into account how salaries and draws are managed. For example, paying wages to your teenage children may be an excellent strategy for your family but they can actually make your net farm income look worse.
Comparing draws, wages, and depreciation between years may help tell a more complete story. “Are these incomes always taken out, and does the statement include direct wages year-to-year?” asks Froese.
Another check is to consider your farm business as an investment. When Froese looks at a corporate balance sheet his eyes immediately go to the retained earnings. “This give a snapshot of the earning capacity of the business over the year,” he says. “But it can be negative if you’re managing the business for the future.”
Whole-farm return on investment is simply net income divided by equity. Profit should yield returns commensurate to the business’s risk, says Small. A farm with higher inherent risk should yield a higher return on its assets and equity.
In the Western world, the return on investment for farms generally averages from two to four per cent. That includes the many Hutterite colonies that MNP serves in Western Canada. “When hard times hit the colonies, you know it’s hard times,” says Small. “Eighty per cent of the colonies have $4 million or more of debt.”
It’s also important to track operational analysis of a mixed farm so you stop investing into the wrong parts of the company. Small advises. There can be huge ranges within and between sectors in the industry.
2. Gross margins and overhead:A key diagnostic tool, gross margin is simple too
When Jonathan Small looks at the financial statements of a struggling farm, he tries to isolate whether the root cause is a production issue or if it’s more related to marketing. Gross margin is a strong indicator of the success of the production and marketing management.
“If the farm is struggling but the gross margins indicate that production is good, then we know our problems lie in the fixed costs,” says Small.
There’s an extra advantage to learning how to interpret gross margin. “Gross margin is simple to use and once most farmers understand what’s included, they realize they carry that information around in their head and they routinely measure its components.”
Gross margin is the extra revenue over the cost of goods sold. These funds are what’s available to cover unallocated fixed costs, returns to unpaid labour, and returns to owner’s or shareholder’s equity.
Remember though that gross margins fluctuate more in farming than in other industries so multi-year trends are essential.
If your income statement doesn’t have a line for gross margin, you can calculate it as the value of the production (yield multiplied by price) minus the expenses directly incurred to generate that production, for example seed and chemical costs. Don’t include variable expenses such as fuel and repairs since they vary according to the size of the operation and don’t directly drive the production per acre or per head. Moreover they usually don’t get measured on an enterprise-by-enterprise basis, which is where analyzing gross margins really shines.
Most telling is to compare each enterprise’s gross margin. Looking at a number of years of gross margins for each enterprise is a good start to optimizing the mix of crops or livestock.
Smalls says if farmers who grow many crops looked at their gross margins, they’d likely find a strong correlation between specific crops and their overall farm performance.
The expenses that you measure with your gross margin calculations are expenses that change quickly. Again, seed and crop protection costs are good examples. However we all know that there’s a lot more to farming than your cash production costs.
Fixed costs and overhead don’t change very quickly and include critical numbers such as capital investment, the main source of interest, depreciation and repair costs.
“Accrual statements are a good guide as to what fixed costs will be in the future and a good indicator of current or past problems,” says Small.
Small suggests looking at trends in fixed costs along with gross margins. “If the fixed costs are steadily rising but gross margin is not, then the end is in sight,” he says. Gross margins have to exceed fixed costs to make a profit.
Some statements show contribution margin. Gross margin includes indirect variable costs like fuel, some custom work fees and repairs. Contribution margin only includes direct costs. With contribution margin, the indirect costs typically get allocated between enterprises in an arbitrary fashion because they are not measured, so caution is needed because they can cloud the analysis, says Small.
Even if the allocation could be 100 per cent accurate you would not be any wiser about enterprise performance than you were when you had the gross margin, says Small. “Often a good deal of work goes into the contribution margin for minimal gain in insight.”
“Perhaps in the western provinces those indirect variable cost differences are not that pronounced but equipment, drying and labour costs can be quite different for corn versus soybeans versus edible beans versus wheat, strong margins (with direct costs only included) in corn versus other crops could be remuch less prominent when you factor in these indirect variable costs,” says OMAFRA adviser John Molenhuis.
3. Liquidity:Balance your loans by calculating your current ratio and working capital
Liquidity is simply a measure of whether your farm can pay the bills as they come due. The common litmus test for liquidity is called the current ratio, which you can crunch right from information on your balance statement.
“There’s a big variation between farms in current ratio,” says Harold Froese, farmer and farm financial analyst from Manitoba. “Current ratio only indicates whether we need to drill down the specifics in the individual farm.”
Don’t sell it short, though, our analysts advise. Sometimes knowing that there might be a red flag is exactly what we need to hear.
Current ratio is current assets divided by current liabilities. A value of less than 1:1 could indicate a developing cash flow problem, although it does vary for individual situations. For example, on supply-managed farms with inflated asset values, lenders may consider a 2:1 ratio as acceptable. “Sometimes banks don’t pay as much attention to current ratio for farms in supply management,” says Mike Terpstra, former manager with the Ontario Soil and Crop Improvement Association, which delivers Growing Forward business management programs.
A current ratio with a very high value may indicate that too many assets are tied up in conservative investments with low rates of return.
Comparing receivables (a current asset on balance sheet) to payables (under current liabilities) can also give a quick picture of how well you’re managing cash flow. It helps to extend repayment terms from suppliers. “To preserve or build liquidity, it helps to collect receivables quickly,” says David Rinneard, national agriculture manager for BMO.
Bankers say that asking questions about liquidity numbers can also help spur a change in how the debt is structured. Structuring the debt so that long-term assets are matched with long-term debt can help the current ratio and cash flow.
“Purchasing long-term capital assets with financing as opposed to with cash lessens the strain on liquidity and spreads the repayment out over a protracted period,” says Rinneard.
Of course, it isn’t healthy to lean too far in the other direction. If the timelines of assets and liabilities get out of whack, you could find you’re left servicing debt on assets you should be replacing.
4. Leverage — compare debt to equity/assets:
The top part of the balance sheet lists the use of the funds — all the assets. The bottom part details where the funds were sourced from — all the liabilities. Leverage then can be calculated with debt-to-equity or debt-to-assets ratios from numbers off the balance sheet.
“Successful farm managers monitor leverage and sensitize their farm business to a host of variables,” says BMO’s national agriculture manager David Rinneard.
While high leverage should generate higher returns on equity for the farm business, it exposes the farm to more risk in an already high-risk business. Also, being highly leveraged means more exposure to rising interest rates.
“As a farm’s debt-to-equity ratio grows so does the farm’s inherent risk,” says Rinneard.
The debt-to-asset ratio is often talked about in general terms of weighing risk. That means the financial position of each farm and each situation is different. Many new farmers are very efficient and can service their debt but are highly leveraged, with a debt/asset ratio often greater than 70 per cent. Others have a high return on assets, but by the time they make their interest and principal payments, so little income is left for living expenses that they rely on off-farm income.
Being in a strong leverage position (often defined as a debt to asset ration of less than 30 per cent), means you can borrow new debt if needed by re-leveraging, or you can borrow against existing assets and provide a needed capital injection to rebalance the farm’s balance sheet.
If the farm is already highly leveraged, you simply don’t have that same chance.
5. Debt-servicing capacity:A debt-servicing ratio below 1.25 may mean danger ahead
Not surprisingly, lenders like to track a farm’s ability to service its loans. Debt servicing capacity is the ability to repay term farm debt from farm and — in the case of some loaning agencies — non-farm income.
On your income statement, look at the non-cash items. Adding the depreciation (also sometimes noted as capital cost allowance or amortization) with the interest and net farm income tells you how much is available for debt servicing.
Dividing that total by the interest payments for the year is the debt-servicing ratio that some banks use as an indication. The higher the ratio, the greater the capability a farm business has to weather any revenue or expense volatility.
Also look at your debt-servicing ratio across a series or years. Is the ratio getting better or worse?
“Generally, the ratio between free cash flow and a farm’s debt-service obligations should exceed 1.25 times,” says David Rinneard. For example, a farm with an annual debt-service obligation of $100,000 should generate free cash flow exceeding $125,000.
When this ratio drops below 1, it can often be immediately detrimental. CG
