Use ratios and benchmarks to analyze performance

Before getting too far into “next year” thinking, it’s important to look at how you did financially in 2017. There are many reason why people farm. One of them though, must be to earn profit.

Four key questions should be addressed:

What profit did the farm earn in 2017?

Profit has must be calculated on an accrual basis, factorin in changes from year to year in inventory, accounts receivable and accounts payable. It includes an allowance for amortization (depreciation) on buildings and equipment. Net cash profit is simply not adequate when determining how much money a farm made, or lost.

How does this compare to past years?

Looking at the profit earned in the most current year provides good information but has to be compared to previous years. What is the trend line? In the past five years, how many have been good? How many poor? The trend line provides a better base of information on your ability to generate profit that you can use when making management and investment decisions for the coming years.

Where did/will your profit go?

Cash is king, especially for farm businesses. Cash can come from different sources, but the only sustainable one is profit. Once you’ve determined how much money you’ve made, examine where the profit is going: capital investment, principal repayment, personal withdrawals and extraordinary items. With that information, align your cash inflow (which is a function of profit) and cash outflow.

Will these levels of profit get you and your family to where you want or need to be in the future?

I ask this question, but usually don’t get a very clear answer. Farm families rarely have thought much about it. But I think there are good reasons why the discussion should become more common.

Higher capital investment, intergenerational transition, narrow margins, changing practices and greater risk are why it makes sense to establish financial goals for profitability.

Many ratios and indicators are available to analyze financial performance. A basket of ratios looks at farm financial performance from various perspectives. They all tell you something about your business financially.

I’ve found the following six ratios to be effective in providing an overview on financial performance. They look at various aspects of the business and paint a picture of your financial situation. Some of the benchmarks will vary depending on the sector you farm in.

The gross margin, net operating profit and operating efficiency ratios provide insight into how financially efficient the farm is at using the investment it makes in the expenses it needs to operate.

The working capital ratio is a measure of liquidity and correlates with cash flow and short-term risk.

The leverage and debt servicing ratios reflect the longer-term risk in the business associated with financing with the debt servicing ratio being a bridge between financial efficiency (profit) and liabilities.

Terry Betker is a farm management consultant based in Winnipeg. He can be reached at 204-782-8200 or terry.betker@backswath.com.

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