There are almost as many financial ratios as seed varieties, and choosing which are most meaningful for your farm — and most helpful for how you manage for success — can be more than difficult. It can be positively head spinning.
Should you track current ratio or working capital? Is ROA a good guide, or would ROI or ROE be better? And what about ATO, depreciation, interest expense, net farm income, and debt payment ratios, all camouflaged in an impenetrable accountant’s dialect?
Yet farmers across the country are also finding it more important to sort their way through the confusion. Staying on top of numbers is more essential than ever because of rapidly fluctuating input and commodities prices, rising capital investment, unstable currency values, larger revenues and expenses, unpredictable interest rates, and aggressive expansion.
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Luckily, we have technology on our side. Today, farmers can track numbers any time and any place thanks to wifi, laptops, smart phones and better financial software. Plus, we’re making big strides in understanding business terms and simply getting used to all those zeroes.
This is especially true for younger, tech-savvy, business-oriented farmers. So who better to ask what numbers they crunch? We linked up with Mark Pawluk, Dave Vandewalle, and Jason Ranger and asked them to share the ratios they track and the tools they use to do it.
Working capital
Jason Ranger farms 4,200 acres near Leask, north of Saskatoon in black soil. He’s been growing wheat, canola and oats for five years and has developed spreadsheets to continually track cost of production and calculate his operating efficiency.
Operating efficiency is defined as operating profit as a percentage of expense.
Ranger uses AgExpert to do his farm books and he pulls numbers from that for his own spreadsheets. AgExpert has some easily generated ratios right in it, like debt-to-assets, current ratios and working capital. Ranger reviews these fairly frequently throughout the year to track debt position and liquidity, and he takes a moment to crunch a working capital ratio too.
Working capital is simply current assets minus current liabilities. The working capital ratio divides that number by the year’s total expenses. The ratio then shows how much working capital you have, divided by how much will be needed over the next year. If that ratio dips below 20 per cent, a farm finances are weak. Ranger’s target is 50 per cent, although between the range between 20 and 50 per cent is considered stable.
Ranger also crunches some bigger-picture numbers annually. While taking the George Morris C-TEAM program, Ranger and fellow participants compared EBITDA ratios, although their farms varied in debt and asset position, cash flow and sectors. (EBITDA stands for earnings before interest, taxes, depreciation and amortization.)
EBITDA margin can be very useful in asset-heavy farming. “Although it bounces around depending on yields and crop prices, overall the trend line is going up,” says Ranger, who has been farming for about five years.
EBITDA is also a measure of cash earnings without accrual accounting, and cancels the effects of tax and different capital structures. This measure is also of interest to creditors since EBITDA is essentially what income a farm has free for payments.
Another ratio Ranger looks at annually is his asset turnover ratio (ATO), calculated as gross revenues divided by average total farm assets. This number depends heavily on how much equipment and land is leased versus owned, and the type of operation. “ATO is a good indicator of the efficiency of assets that you own,” Ranger says.
Ranger keeps a laptop with him so he can update his input costs in real time on his own spreadsheets. This year he’s going to try FCC’s Field Manager PR, again. “I tried it a few years ago but all I had was a Palm Pilot and it just wasn’t easy to work with,” he says. “With a laptop it should be easier.”
Ranger is also a member of a benchmarking group, AgMpower ( www.agmpower.ca) so he can compare his input costs online as he’s making buying decisions.
Ranger says the group’s breakdown of overhead expenses and variable input costs into individual categories is more useful in a group of similar-type operations. “The guys in that group are the ones I want to be benchmarking against. They’re leading edge producers,” says Ranger.
Also, on AgMpower’s web-based spreadsheets, futures prices are automatically downloaded from the commodity exchanges so Ranger can just plug in his own basis to instantly get numbers to make marketing decisions. Although this didn’t change how he executes his marketing plan, it’s more easily organized. For example, he tracks his basis contracts on the spreadsheet instead of scrambling through a stack of papers.
Using this tool helps him keep on top of both parts of the balance sheet. “I can see my financial position every day,” Ranger says.
Ranger admits he doesn’t always follow what the ratios are telling him, especially about land. “I’m in expansion mode so when land comes up I’m going to take it.”
As in most parts of Canada, the competition is heavy for buying or renting land near Leask. “Rental always pencils out better but I want to buy land as an investment,” says Ranger. “With buying there’s certainty and long-term appreciation in land values.”
Opportunity costs
Mark Pawluk’s BlackBerry starts buzzing at 6:10 a.m. and doesn’t stop until 6:10 at night. In between, his day is overflowing with information — market updates, world news, agronomic advice, equipment offers and a constant stream of emails.
Finding the nuggets in this unending stream is like selecting which ratios really make a difference to his farm. Pawluk’s strategy is to keep it simple. He focuses on getting the macro things right. Then his other ratios will be in line.
One calculation Pawluk finds particularly important for his 6,000-acre grain and oilseed farm at Birtle, Man., is operating efficiency, calculated as operating profit divided by total revenues. If a farm is less than 25 per cent efficient, it needs improvement.
Above 40 per cent is highly efficient, and that’s exactly where Pawluk aims to be.
“Whether you farm 25,000 acres or have an 800-acre hobby farm, operating efficiency can apply,” Pawluk says. “It red flags a whole-farm problem quickly.”
For a big picture perspective, Pawluk applies operating profit to something he learned from a course while participating in the C-TEAM program offered by the George Morris Centre in Guelph.
Pawluk splits how whole-farm operating profits are spent into four quadrants of a circle. Family draws and interest payments are the two sections in the top half. Debt reduction and asset growth are the two that make up the bottom half.
Pawluk believes it’s important for a young farmer like him to spread the profits out more or less equally among all four quadrants, remembering that they can never exceed 100 per cent of the available profits. However, more established farmers who aren’t as indebted or expanding and who spend less on interest and debt repayment can inject the majority into asset growth and family draws.
Key rules that he learned at C-TEAM include that interest costs shouldn’t exceed 25 per cent of operating profits, and the combination of family draws and interest shouldn’t exceed 50 per cent, says Pawluk. It’s advice that helps him balance paying down debt, growing assets, and providing for owners.
When a quadrant gets out of balance with the others, it’s what Pawluk focuses on, which means this simple circle also helps him to balance out debt repayment with growth or asset accumulation. It can also help diagnose why a farm is at low efficiency, for example, or why it is running out of cash or if it should expand.
For his own farm, Pawluk’s current goal is to improve efficiency and maximize returns per acre. The farm is in the middle of succession, and his parents, Brian and Brenda, have recently retired.
For marketing, Pawluk uses return on investment (ROI) per acre as a sell signal. Effectivley, it’s a sort of litmus test that gives him perspective for top-end pricing.
With average yields this year, some farmers will be approaching 100 per cent ROI. “ROI is my simple acid test,” Pawluk says. “What’s my net return per acre?’
Although it’s not the only thing Pawluk watches, ROI is an indicator that gives him courage to sell. If the market goes up the next day, he doesn’t worry about it because he knows he’s made a good return.
For Pawluk, ROI per acre is taking the next step past cost coverage. “I’ve always known my cost of production, but if you’re not measuring opportunity costs, so what?” he says. “I mean, when prices are considerably above your break-even, when do you sell?”
The topside of the 2011 market is relatively new territory for most of us, including most marketing experts. The lessons from 2008 are still ringing through the countryside. There’s serious money to be lost in those peaks, and a strong market can end abruptly, just as it did in 2009.
“Selling too early is like selling too late. There are the opportunity costs,” says Pawluk. “If you’re not catching the highs, the lows are going to kill you.”
“This volatility is lethal,” Pawluk says. “If I’m making mistakes marketing, it doesn’t matter what ratios you’re watching or how good your cost analysis is.”
This spring Pawluk’s focus has been on forward sales, and he’s recently invested in a new air drill to help get crops in the ground quickly.
During times when margins are tighter, Pawluk focuses his marketing on costs of production. Using Ag Expert he has his cost of production for each crop at his fingertips.
“If we only have $30 per acre returns I don’t look at ROI as closely for my marketing decisions. Instead it’s about margins,” Pawluk says. “But for now I’m trying to get as much money off the table as I can.”
Margins per acre
“I’ve got spreadsheets and pieces of paper that I jot notes on all over my office,” says 40-year old Dave Vandewalle. “Not everything is formalized but I’m always thinking about these things.”
Vandewalle grows 1,100 acres of corn, wheat, soybeans and edible beans and finishes 7,000 hogs a year near Dublin, Ont. with his wife Lisa and father Gerard. He’s also a big fan of using sensitivity analysis to help him make expansion, marketing, production and buying decisions and he is continually learning and looking for opportunities.
Gleaned from data in his bookkeeping program, QuickBooks Pro, Vandewalle can quickly calculate and keep track of margins per acre or per kg, and can track cost of production on his own spreadsheets. In the program’s profit and loss statements and balance sheets, he can easily zoom in and look at transaction details, like a summary of seed purchased or corn sold.
“How much I’m willing to pay for inputs and assets is based on knowing what our management can generally produce,” Vandewalle says.
Vandewalle uses his own spreadsheets to look back and compare his day-to-day decisions like cost of inputs or marketing. “Spreadsheets are more useful to keep track of inventory, contracts and average prices of both inputs and sales,” he says.
About once a month, Vandewalle reviews the cost of liquid versus dry feed to select the lower input cost and determine margin per hog. From there, he can lock in futures pricing on finished hogs as opportunities arise.
“I work off of averages. For example, feeder hogs have ranged from $40 per pig in 1998 to $200 per pig so I try to use the average over the last four to five years,” says Vandewalle.
He continually follows market prices for hogs and crops on his BlackBerry. For commodities, one of his favourite web sites is Hensall District Co-operative’s ( www.hdc.on.ca). This website gives a snapshot of the current market for the crops he grows, and is directly updated from the exchanges. “This way I can see futures and basis to give a current cash price,” Vandewalle says.
Tracking prices is particularly important to his crop marketing strategy. Vandewalle focuses on cost of production and then tries to market at a profit using incremental selling. “For crops, this can stretch beyond a 12-month calendar year,” he says.
Every two or three months, Vandewalle also takes a few minutes to project payments (including interest and principle) versus income to review his cash flow position and keep on top of his ability to make payments. “Maintaining a good line of credit is important,” he says.
Annually, Vandewalle also chats with his banker about his debt repayment capacity, and at the same time they assess the whole farm’s sensitivity to different interest rates. With such huge fluctuations in hog, grain and oilseeds prices, Vandewalle sleeps better with a balanced approach to fixed-rate mortgages, especially on long-term investments like land.
Vandewalle breaks his debt capacity into three risk groups. “There’s the stuff we can pay for in the next year, the stuff like some machinery which we look at a five-year payback and long-term debt,” says Vandewalle. “Land is an asset that will keep on producing and keep making money so I view it differently.”
Vandewalle grows commodities in some of the most expensive farmland in Canada, with land in his area trading at $10,000 or more per acre, and he works to base land-purchase decisions simply on whether the total farm can afford to make payments over extremely long terms.
It’s just the reality of farming, he says. “20 years ago everyone said land was too expensive at $2,000 per acre and it just keeps going up and up.”CG
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Expansion number check points
With no-till and with today’s larger equipment, farmers can expand at a much faster pace than previous generations. It’s not uncommon to see a farm double its seeded acres from one year to the next.
At a fast rate of growth you have to manage market and production risk well and ensure long-term access to land. “With this ability to expand to such a large degree, there are a few factors that become even more important to ensure our farm businesses grow at a sustainable and profitable pace,” Alberta farm adviser Mark Muchka told a workshop for accountants this winter.
Focused on expanding grain farmers in Western Canada, Muchka recommends numbers to watch that go beyond the typical debt assessments.
1. Operating loan plus accounts payable should be less than 50 per cent of unsold inventory plus accounts receivable.
2. Operating expenses should be less than 65 per cent of gross revenue (averaged over past four years).
3. Machinery investment should be less than 1.5 times gross revenue per acre, or machinery leases should be less than 15 per cent of gross revenue.
4. Net Income should be greater than two times the cash rent that could be received from the land.
5. Debt should be payable in less than five years if all net farm income were directed to payments.
6. Net Income (excluding government programs and interest costs) should be greater than 20 per cent of gross income (excluding government programs).