A key motivation in farm business management is increasing shareholder or owner value.
This is accomplished by sustaining profit over the years and leaving as much of it as possible in the business.
A farm can increase its value through capital appreciation of land and quota.
There is also an accumulation of machinery and buildings, but that is not usually factored into the discussion. For purposes of this discussion, increases in market value of assets are not included.
An investment is required to generate the profit. The question is: where do you get the best return on the investment?
When I talk to farmers or students, it helps to separate the discussion about the form of the investment.
For example, is the investment in capital assets or operations?
Many farmers think there is a divide between capital and operations. They don’t consider their operating expenses, both variable and fixed, to be an investment, at least not in the same context as buying land.
They’re obviously not the same, but both are invested in the business, and there should be an expectation of a return.
For example, imagine a farm with no assets. It rents all the land and leases equipment and buildings.
The only investment is in operations, and the expectation of a return on the investment depends on how efficiently the expenses are used.
As soon as there is an owned asset — an acre or piece of equipment — there is an investment in capital and, similarly, an expectation of a return.
So, what can you do to analyze the investment options?
There are ratios that analyze business performance on both sides of the “capital-operations divide,” and there are some linking ratios that look at the relationship between them.
Return on assets is a ratio that measures the return on the investment in capital. A simplified calculation divides net income by total assets.
A different measurement, the asset turnover ratio, is calculated by dividing gross revenue by total assets. Notice that the numerator is gross revenue and not net income. This tells you how efficiently you are using assets and converting them into gross revenue or sales. The theory is that you need to start with sales (gross revenue) to get to net income.
One way to improve profitability is to reduce the investment in capital, but what is the best way to do that?
Lots of variables enter into the discussion about capital investment, things like the availability of land and tax strategies associated with leasing or owning equipment.
There is no one right way to do things. But one thing is certain: a business must be as efficient as possible in generating a return on investment, whether it’s in the form of capital or operations. A business that cannot achieve operating profit over time is not sustainable.
If you are over-capitalized, it will be more difficult to convert the investment in capital into sales that ultimately generate net income.
There is another factor to consider. Because farming is capital intensive and capital investments are expensive, the investment is often financed.
The financing comes with a cost, so the return must be large enough to cover the cost of capital and still realize a return over the cost. Interest rates are low, so generally this isn’t as much of an issue as it was in the past.
Owners or shareholders want to see the value of their business grow. This requires maximizing the return on the investment that’s made in the business, whether it’s in the form of capital or operations, than it is about owning assets.