Minding Ag's Business

Financial Ratio Relationships: Understanding Cause and Effect

The DuPont Financial Analysis Model was originally developed as a tool for analyzing the rate of return on assets, but with a simple step, it can also be used to analyze the rate of return on equity. (Courtesy graphic)

Most farmers that do look at their financial ratios analyze either their trends over time or relative to benchmarks; e.g., their own history, published numbers, other farmers or their lender's standards. All of these are useful, but it's also helpful to dig into what is driving their bottom line and to do "what if" analysis to see the impact different changes would have, i.e., where they would get the biggest bang for their buck. It is also useful to take a deeper dive to determine causes rather than treating symptoms when they review their results.

What I'm really talking about is the DuPont Financial Analysis Model. Because of the limited space, this will be a fairly brief summary. The model was originally developed as a tool for analyzing the rate of return on assets (ROA), but with a simple step, it can also be used to analyze the rate of return on equity (ROE).

At the heart of the analysis are two financial measures: your operating profit margin (OPM) and your asset turnover ratio (ATR), or "earns" and "turns," as Mike Boehlje often refers to them.

OPM measures the businesses before tax returns in relation to total revenue and is calculated: (net income from operations + interest expense - family living withdrawals) / gross farm revenue.

The ATR measures how efficiently the business' assets are being used to generate revenue and is calculated: gross farm revenue / average farm assets.

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The ROA measures the business before tax returns in relation to the business' total assets and is calculated: (net income from operations + interest expense - family living withdrawals) / average farm assets.

Because the numerator in the OPM is the same as the denominator in the ATR, when the two are multiplied, gross revenue cancels out and you are left with the ROA.

In order to increase OPM, the business needs to increase the average price received through better marketing and/or decrease operating costs or lower family living costs.

In looking for ways to decrease costs, it is insightful to first look at the percent of total operating costs made up by each expense category. Options some farmers have used include auto-steer; variable rate applications of seed, fertilizer and chemicals based on site-specific performance records; selling unproductive assets; double shifting; leasing versus purchasing some assets; or having some work custom done when the asset required is very underutilized on the farm. Others collaborate and jointly share some assets, people or equipment in order to spread the costs.

Centrec Consulting and Wittman Consulting both have downloadable spreadsheets to do the calculations:

http://www.centrec.com/…

http://www.wittmanconsulting.com/…

Using the DuPont Financial Analysis Model, net farm income from operations can be analyzed in more depth by breaking costs into categories as a ratio of the individual costs relative to net farm income from operations. This can help you analyze what effect cutting back specific costs would have on ROA or ROE. Furthermore, you could look at the effect of changing interest rates on specific loans or reducing assets by getting rid of unproductive assets. The same could be said for looking at a reduction in living costs.

I just think it is a good tool for analyzing causes and doing "what if" analysis. It gets away from looking at symptoms and guessing what caused the result.

Danny Klinefelter can be reached at Talk@dtn.com

(AG/BAS)

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