Back to the Basics With Benchmarking
Farm Management Update, February 1997
By David M. Kohl, Dixie Watts Reaves, and Amanda J. Wilson of the Department of Agricultural and Applied Economics and Troy D. Wilson of business administration, Virginia Tech,
The late 1990s is a new era of agriculture that is separating the winners and losers in the agricultural arena. With the reduction of farm program payments and more responsibilities for management being placed upon the decisions made in finance, marketing, and management, it is becoming critical that a producer develop financial benchmarks for success. With the adoption of farm financial standards and with producers utilizing better records, benchmarks are emerging nationwide to measure business performance.
Benchmark data summarized and applied to ratios in Weighing the Variables, by David Kohl, Department of Agricultural and Applied Economics, Virginia Tech, 1992, is presented in Exhibit I. The chart represents 5 years of data from 485 farms in the Midwestern United States covering all commodity types. The ratios provide benchmarks to which individual producers anywhere can compare their business performance. This article will examine these ratios and benchmarks applied to an actual farm situation (Exhibit II).
Two measures of liquidity, the amount of cash available without disrupting normal business operations, are the current ratio and working capital. To calculate the current ratio, refer to the examples in Exhibit II. It is noteworthy that of the 485 farms analyzed, the top 20 percent had a current ratio of 1.9; the average was 1.49; and the bottom 20 percent had a ratio of 1.06 (Exhibit I).
A low risk business, or "green light", usually maintains the current ratio above 1.5. As the ratio approaches 1 to 1 or under, concern should arise on the part of the producer or lender, because it should signal insufficient cash or working capital for timely repay debts or expenses. Factors influencing the interpretation of the current ratio include time of year, enterprise, and debt structure. For example, contract poultry or hog operations and dairy operations will frequently have lower ratios. Exhibit I also illustrates that top producers have about 20 times more working capital than the lower 20 percent of producers: $114,143 compared to $5,690. If intermediate or long-term assets such as machinery or land are purchased and financed, it is critical to maintain a strong working capital position both before and after purchase to ensure that sufficient levels of cash are available in the event of unexpected expenses or market disruptions. A general measure of working capital is working capital as a percentage of farm expenses (including depreciation). Working capital of 20 percent of farm expenses is considered sufficient.
The farm debt-to-asset ratio, based on the market value of assets and liabilities, measures financial risk with debt financing. Data from Exhibit I suggest that the top 20 percent of profitable producers had an average debt-to-asset ratio of 45 percent, as compared to the bottom 20 percent, who had a ratio of 66 percent. When this ratio exceeds 50 percent, management must demonstrate certain skills in order to succeed financially. As production managers, they must be in the top 20 percent controlling production costs; as marketing managers, they must be in the top 25 percent controlling marketing costs; as household managers, they must keep living expenses between $20,000 and $30,000 annually; and generally, they must have, for lack of a better word, a little "luck."
Profitability of a business is its life blood. There is an old saying that goes: "You don't work for the business; the business must work for you." Net income and rate of return on assets are two measures of profitability. Exhibit I shows that the top 20 percent of producers generated $75,687 of net income while the bottom 20 percent had negative profits. Analyzing rate of return on assets (ROA) shows that the top 20 percent had nearly an 8 percent return while the bottom 20 percent had a negative ROA. Case study experience indicates that in agriculture the middle class, in terms of profitability, is being reduced rapidly. It appears that producers are either getting better or rapidly falling behind. In business situations, the decline of profits is an early warning signal that cash flow and repayment problems are just around the corner. When profits are declining, the underlying problems are often a lack of size and scope of the business, too many underutilized assets (both capital and human), high overhead, and poor cost control.
Repayment ability measures a business's capacity to provide a living for the owner and meet all expenses and debt payments. The term "debt coverage ratio" is a common benchmark used to evaluate repayment ability. Exhibit II illustrates how to calculate this ratio. Debt coverage ratio is calculated on an accrual basis, that is after all inventory, accounts receivable, and expense adjustments have been made to the net cash income. Data from Exhibit I suggest that the top 20 percent of producers have a 290 percent capacity to service debt payments while the average is about 139 percent. Examination of the bottom 20 percent of producers reveals there are insufficient earnings generated by the business to support repayment, with a ratio of only 24 percent. Thus, farmers in this category must resort to non-farm earnings or delay payment of expenses or debt, or both. In today's agriculture, agricultural producers should strive to keep the debt coverage ratio above 125 percent, if at all possible.
The final area of examination is financial efficiency which is measured by using the operating expense/revenue ratio. This ratio indicates how much investment it takes to generate a dollar's worth of revenue in a business. Exhibit I shows that the top 20 percent of producers generate a dollar's worth of revenue before interest and depreciation on 67 cents. The average is 75 cents, while the bottom 20 percent of producers take nearly 91 cents to generate a dollar's worth of revenue. This leaves only 9 cents for debt payments, living expenses, income taxes, and capital expenditures. Businesses in this performance category frequently rely on non-farm income or have very low levels of debt. Large businesses (over a million dollars in revenue) and producers that lease considerable assets, corporate producers, and contract owners will generate a dollar's worth of income with 80 to 85 cents. This level is still an adequate performance measure because lease payments are being traded for debt payments. Corporate producers and large businesses, unlike a sole proprietorship, deduct corporate salaries, which makes the ratios more comparable. Contract growers have the advantage of reduced market risk because of guaranteed markets. It is noteworthy, however, that the difference between the top producers and the bottom 20 percent is nearly 24 cents in efficiency: a clear indicator that top performers truly have their business working for them.
Case Summary and Conclusions
In summarizing our case study, results in Exhibit II find some definite strengths and weaknesses. One major strength is operating efficiency, which is 65 percent. It results in a profitable operation that is generating nearly 8 percent ROA. This farm would definitely be in the top 20 percent of producers in these categories. In ranking strengths, the coverage ratio is strong at 177 percent, though not in the top 20 percent of producers. The debt to asset ratio, which is 42 percent, indicates a "yellow light" for the top 20 percent. The major financial weakness in this case was liquidity. The current ratio was just above 1 to 1 and working capital was $3,408, less than one percent of farm expenses, which is a "red light."
The Rest of the Story!
In this particular case, the producers had just expanded business operations. Cost over-runs had occurred in the expansion process, which resulted in reduction of internal working capital. The lender and producer had poorly structured debt with repayment terms that were too short resulting in pressure on cash flow and liquidity. The recommended solution was to curtail further expansion, refinance debt on longer terms, and build working capital and liquidity in the short-run through profits and earnings generated from the business, as well as non-business earnings.
Exhibit III demonstrates how this systematic analysis can be incorporated into strategic planning through prioritization of goals and objectives in the short and long run. Financial measures falling in the bull's eye are strong points, and should be maintained. Measures that are off target indicate areas for improvement.
Visit Virginia Cooperative Extension