Profit, or lack of it, is the number on the bottom line of your annual report.
Or is it?
A lot of revenue that contributes to the bottom line can be generated by activities not considered part of the core business.
However, it’s the profitability of the core business that will sustain your farm over the long term, and so it is important to measure and track core profitably.
I’ve seen farms where the financial statements reported a profit but in reality, the “farm” was losing money. The non-core revenue was painting an inaccurate picture.
It can be a real problem when the farmer isn’t aware that this is happening.
Net operating profit is the financial term for profit that the business generated from core operations.
However, before looking more deeply at net operating profit, let’s look at examples of non-core revenue:
- patronage dividends
- incidental custom work
- purchases or sales of breeding livestock, unless it’s a purebred business
- gains or losses from the sale of equipment and buildings
- government programs such as Agri-Stability
- leases from oil wells and other properties
Revenue from these sources needs to be on the income statement, but it is typically not revenue from the farm business’s primary purpose, which is likely selling crops, livestock or dairy.
These peripheral revenues should not be included in the net operating profit calculation.
Government programs such as crop insurance payments are considered to be revenue from core operations because income from these sources correlates exactly with production.
An Agri-Stability payment is related to production too, but the argument for not including it as core revenue is because of the uncertainty in the program’s longevity. Farms aren’t in the business of farming programs, and most farms want to know how their business is performing financially without government support.
The first step in calculating net operating profit is to determine what revenue should be included as core and non-core.
The next step is to subtract expenses that were incurred to generate that revenue. These include production related costs, other variable costs such as fuel and repairs and maintenance and all fixed costs such as interest, property taxes, rent and utilities.
The calculations should be based on accrued financial information for this analysis to be most beneficial. Changes in inventories, accounts payable and receivable and depreciation or amortization need to included.
To analyze how net operating profit affects efficiency, we need to convert net operating profit into a ratio.
This is calculated by dividing the net operating profit margin by gross revenue. The indicator examines how efficient a farmer is at generating a margin of profit from core operations.
Farms must generate a positive net operating profit margin from core operations over time to be sustainable. Consider making adjustments to account for wages and salaries to family and management. Are they in line with industry standards?
Amortization (depreciation) rates can significantly affect performance and should be calculated based on management rates rather than tax rates and applied on a straight line basis.
A higher ratio indicates better performance. A farm generating more than a 20 percent net operating profit margin ratio indicates an extremely efficient farm business. The business will thrive if this level of profit is sustained over a long time.
A 10 percent or lower ratio indicates that the business may have room for improvement.
Remember that the denominator is gross revenue, which means that if a farm’s net operating profit margin is $100,000 and its gross revenue is $1 million, then its net operating profit margin ratio is 10 percent.
If the profit margin was where it should be at 20 percent, then the margin would be $200,000, providing an extra $100,000 that could be used for investment and growth, re-paying debt or for personal needs.
This is money that other farms with better performance use to give themselves a competitive advantage.
Long-term sustainability is threatened if the net operating profit ratio approaches zero, or worse.
The trend line is important. Are things getting better or worse? In a worsening situation, what can be done to make improvements? There are things that happen outside of a farmer’s control, but the focus needs to be on controlling what can be controlled.
Options include increasing production, decreasing expenses, deferring capital purchases and making adjustments to management withdrawals.