Use Financial Metrics to Make Informed Decisions
Gauge Your Bottom Line
Marc Arnusch's family began growing sugar beets in Colorado's Prospect Valley in 1952, so when he decided to exit that business five years ago, it left many in his family scratching their heads.
"Everybody thought I'd lost my mind, including myself from time to time," he says. "It became apparent that was not just a good decision, it was a great decision, and it's because I trusted the numbers."
Arnusch had been watching his asset turnover ratio, which measures his farm's revenue compared to its assets, and it uncovered two problems.
"We were making a little bit of money, but we had so much capital tied up in assets and manpower. Then, I was also starting to lose revenue on the ownership side of the company itself," he says. "The only way I was able to flush that out was through a metrics analysis. As hard and as emotional as that was, the numbers were telling me to get out and get out now."
He sold his sugar beet equipment and co-op shares, and reinvested the capital into his certified wheat and barley seed business, as well as his craft grains business. He built grain storage, bought a commercial seed treater and purchased a combine dedicated to those value-added business lines.
"I was able to do that with almost zero cash outlay because I converted my assets. I went from an underperforming metric to what happened to be an overperforming metric in less than a year."
METRICS GUIDE DECISIONS
The asset turnover ratio is just one of 16 financial metrics Arnusch uses to guide his decision-making. He relies on certain ratios more than others, and the numbers he watches closely have changed over time.
"Ratios tell a lot about our farm and what's working and what's not," he says. "So long as the numbers are correct, numbers really don't lie."
Farm Credit Services of America Senior Vice President of Retail Credit Chad Gent says many farmers are sitting down with their lenders this time of year to talk about where they're at financially and what success in 2023 and beyond looks like.
"It's really critical to figure out how to leverage the strength producers have right now," Gent says, adding the financial position of his customers is perhaps the strongest it's ever been. USDA expects net farm income to climb 13% from last year to $160.5 billion, and that's despite a record-breaking rise in production costs.
Gent says there will be margin compression in the grain markets, it's just a question of when.
"When we're dealing with a commodity business, low margins are the rule. We're in the exception right now," he says. "We know it's going to change, so what do we need to do to be prepared for that and to take this next adjustment, not necessarily in stride but make it a lot easier than the last business cycle that peaked in 2012 and 2013, and went downward through 2019?"
Agricultural economist and co-founder of Agricultural Economic Insights David Widmar likes to say that working capital is the original risk-management tool. To estimate working capital, farmers should tally any assets that can be converted into cash within the next 12 months, including items like grain and livestock to be sold in addition to savings accounts. Then, subtract any liabilities, like debt payments and bills, due in that time frame.
"It gives us an idea of how much shock absorber we have, how much flexibility we have in our balance sheet to weather any difficulty that comes our way."
Widmar says once a farmer has his asset and liability figures, he can create a number of ratios. The current ratio is a common one. It's computed by dividing assets by liabilities.
Arnusch says the current ratio drives a lot of his financial planning, especially managing cash, but there have also been times when it's given early indications a business is underperforming. When he reviewed his sugar beet operation, it looked OK from a return-on-investment standpoint.
"But, we were bleeding cash out of the operation, and the only way I could really see that coming was through that current ratio," he explains.
Gent says sometimes farmers have a hard time connecting with the current ratio, so he suggests looking at working capital on a per-unit basis, such as dollars of working capital per head or per acre. For example, if a farmer has $200 of working capital per cow, and he loses $200 a calf, he has enough working capital to cover one year of losses.
Another way to think of it is to calculate working capital to gross revenue by dividing working capital by gross farm income. Historically, bankers consider a farm on solid footing if the ratio is 25% or higher.
"Most of our producers are carrying two to three times that," Gent says. That means if a farmer has 50% of his gross farm income in working capital and a 10% loss in gross farm income for three years in a row, he'd still meet many lenders' standards for working capital.
"Working capital keeps the producer in control. They call the shots when they have the liquidity," he says. "Down cycles usually bring opportunities, and they can take advantage of opportunities if they manage their debt levels, and their working capital is as strong as possible."
When farmers think of solvency ratios, minds instantly go to the debt-to-asset ratio.
"I think the reason why is that it was the canary in the coal mine for the 1980s farm crisis," Widmar explains, adding that it might be the wrong warning sign to watch right now.
Gent says soaring asset values, especially for farmland and real estate, have boosted equity on farmers' balance sheets. That makes the ratio look stronger, but "the return on real estate has never been lower," he adds. That means the ratio, which lenders usually want to see below 30%, needs to be even lower to indicate the same amount of strength.
"My observation is higher equity is no longer a guarantee of strong earnings. But, low equity is typically a predictor of poor earnings," Gent says.
Arnusch agrees that debt-to-asset has its flaws. In his community, land values are driven by water and the proximity to the mountains. "It's almost an artificial value," he says, adding he tries to focus on metrics that show how his farming operations are functioning.
Widmar suggests monitoring the debt service coverage ratio instead. This ratio indicates repayment capacity, or how much of a business's cash-flow is required to meet debt obligations. Since it includes both components of revenue and debt, it moves when either piece rises or falls.
"This ratio can move really quickly," he continues. "If we see this metric start to creep up, it's a bit of a warning sign."
In the 1980s, the sector-level debt service coverage ratio climbed above 30% and almost got to 45%, meaning nearly half of the income from farming was being used to pay down debt, Widmar says.
The picture is different today. Over the past few years, farmers have taken advantage of historically low interest rates to refinance long-term debt. Gent says those decisions are almost magical for many balance sheets.
"Long-term, low-interest debt has probably become one of the highest value assets for producers," he explains. "It puts them in a position for that debt to be very manageable long term." Gent recommends not paying this debt down early unless there's a good reason, like retirement or an overall plan to become debt-free.
Like the debt-to-asset ratio, the debt service coverage ratio will likely be inflated due to two years of strong farm incomes. "If they use the last two years of earnings as a gauge for debt service capacity, it's going to be one of the biggest mistakes our producers could ever make," he says.
Gent suggests looking at the longer-term trend of the ratio to get a feel of what's reasonable for your farm. It may be helpful to think of overall debt commitments on a per-acre basis to help decide whether you can afford that equipment or land payment.
One of Arnusch's favorite metrics is the operating profit margin ratio. He looks at it for a reflection of his total business, but he also uses it to assess each enterprise or farm. "We've discovered, maybe by accident more than anything, that we have some farms that are underperforming. It's not necessarily that the soils are poor. Part of it was the way we managed it."
Farmers need to calculate two things to find their operating profit margin ratio. First is their return on assets, which is calculated by subtracting the value of unpaid labor and management from net income and then adding any interest expenses. Second is gross revenue.
The challenge in this part, Gent says, is properly calculating net income for a given crop year. "To really get the best picture, it requires the allocation of expenses and income to the appropriate business cycle," or accrual accounting, he says.
That means income on a tax return doesn't work well for this purpose, because tax returns usually include revenue and expenses from three operating cycles, such as sales of old-crop grain, sales from the current crop year and prepaid expenses for the upcoming year.
Accrual accounting requires additional recordkeeping, and while it's something not all farmers want to invest their time in, Gent says it gives the best information. Farmers can do a balance-sheet-to-balance-sheet assessment instead, but it's not as robust as true accrual accounting.
Arnusch says there are benefits to the cash accounting method, especially for understanding the cash-flow demands on a business and for tax purposes. "But, cash accounting can really misrepresent what a farm's true profit really is," he says.
Widmar stresses it's important to start somewhere. "Rome wasn't built in a day, and you're not going to be able to get a financial system like a Fortune 500 company overnight. A few years of data can help us understand our trajectory, and pairing that up with our goals can help us, as managers, prioritize and create alignment in our business."
5 NUMBERS TO KNOW:
Monitoring a few financial metrics can help growers make better-informed decisions. A few ratios -- like the debt-to-asset ratio and return on investment -- may be popular, but experts say they're not as informative as some might think. Instead, here are five metrics to evaluate.
1. Working Capital
-- Assets / Liabilities
-- Shows ability to withstand financial loss.
2. Working Capital to Gross Revenue
-- Working Capital / Gross Farm Income
-- 25% or more is considered sound enough to withstand potential losses without selling assets.
3. Debt Service Coverage Ratio
-- Net Farm Income / Annual Debt Obligation
-- Measures how much of annual cash-flow is needed to meet principal and interest obligations.
4. Asset Turnover Ratio
-- Total Revenue / Assets
-- Measures how efficiently a farm's assets are being used to generate revenue.
5. Operating Profit Margin
-- (Net Farm Income + Interest Expense - Unpaid Labor and Management) / Gross Revenue
-- Measures the ability of a farming operation to generate profits.
-- Read Katie's business blog at https://about.dtnpf.com/…
-- You may email Katie at firstname.lastname@example.org, or visit @KatieD_DTN on Twitter.
(c) Copyright 2023 DTN, LLC. All rights reserved.