In good times or bad, there are some basic financial tools that allow farmers (and other managers) to gauge their operating efficiency, diagnose where they have problems, and measure the financial risk they are bearing or are about to undertake when they make a substantial investment.
We find, however, that we hear very few people talking about these tools or how to use them.
This is the first of a three-part series that will address some of those basic tools. Because of space restrictions, we need to limit the amount of accounting definition that’s included. Be sure to get detailed information when you try this at home.
The financial measures discussed in these articles are based in whole or part on the concept of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). This is a long-winded way of describing operating income, or what you have left after you pay your operating expenses and before you deduct your cost of capital. For some reason, this measure, used constantly in business in other industries, is not talked about very much in agriculture. It’s a pity, because it’s so useful.
Below is a 14-line representation of a farm’s income (operating) statement. We divide costs into six categories. Subtracting direct crop and livestock expenses from gross revenue gives gross margin. Then subtracting operating costs such as labour, machinery operating expenses and land rent gives what we call contribution margin. Then, by subtracting the farm’s overhead expenses, we get EBITDA.
Gross Operating Revenue
- (-) Crop and Livestock Expenses
- (=) Gross Margin
- (-) Labour, Machine Operating Expenses, Land Rent
- (=) Contribution Margin
- (-) Management, Office and Overhead Expenses
- (=) EBITDA
- (-) Depreciation/Amortization
- (=) EBIT
- (-) Interest
- (=) Earnings Before Taxes
- (-) Taxes
- (=) Earnings After Taxes
- (+/-) Non-Core Income and Expenses
- (=) Net Income
Notice that all of the expenses deducted to get to EBITDA are operating expenses; they don’t directly include the cost of capital. We want to separate them completely from capital expenses, so we can compare different years and, when appropriate, benchmark against other producers who may have very different debt structures than ours.
After deducting depreciation and interest we get earnings before taxes, and then we deduct taxes to give net income after taxes.
The next-to-last line is an interesting one. This is where you put all that stuff really not related to your core farm operation. This would include government payments, payments for driving a school bus, custom work if it’s not core, and the expenses incurred to soup up your pickup truck for racing on Saturday night (as well as the prize money that you win!).
This approach makes it relatively easy to standardize financial statements using the definitions of the cost categories. Often with farm data, we can get good benchmarks for well-managed farms. What is “well managed?” It is an operation that is efficient at generating operating income. This gives rise to a very useful ratio to measure “operating efficiency.”
If we simply divide EBITDA by gross operating revenue, the ratio measures how many cents of operating income are generated by the farm per dollar of gross revenue. Lots of data from both Canada and the U.S. shows that for most crop and livestock farms, the ratio should be 35 per cent or higher (usually averaged over a number of years). In other words, after paying all operating expenses, the farm should have $0.35 left per dollar of gross revenue.
Work done several years ago by Al Mussel at the George Morris Centre showed that there is huge variation in this measure among Canadian farm tax filers, but that the ranges aren’t much different whether they are beef, hog, cash grain or dairy farms, or whether they are large or small operations.
The average was 22 per cent, far lower than our benchmark. At the same time, all groups had a number of farms which were at or above the benchmark. Farms chronically below 25 per cent are generally not growing and not overly successful. Those with ratios below 20 per cent are often in difficulty.
For farms that do not achieve the benchmark, there are some further benchmarks to help diagnose what the problem is. We will focus on these in the second of this series of articles.
Larry Martin is co-owner and lead instructor in AME’s management training courses. Heather Broughton is co-owner and president of AME.