Less gross revenue being generated from capital assets

I recently made a presentation on financial benchmarking at Farm Management Canada’s Agricultural Excellence conference in Ottawa.

I looked at data that we capture in our EAGLE farm business management software program. The program analyzes the financial performance of individual farms and aggregates the data from participating farms. Individual farms can compare their performance to the aggregated data, which effectively becomes a benchmark.

The program examines past performance and displays multi-year trend lines, which are a function of the events that have occurred and decisions that farm families have made in the past that affect farm financial performance.

Different ratios will display different trend lines, depending on the events and the decisions. Trend lines can strengthen or weaken over time or they can simply fluctuate with year-over-year variable results.

The capital turnover ratio is a profitability ratio and has a potentially troubling trend line when examining an aggregate dataset over the past 10 years.

The capital turnover ratio is calculated by dividing gross revenue by capital assets, which are land, buildings, equipment, quota and breeding livestock. This ratio indicates how efficiently a farm uses its capital assets to generate gross revenue (sales). The higher the ratio, the better the assets are being used.

Here’s an example. A farm has $4.5 million in capital assets and its gross revenue (sales) are $1.5 million, which translates into a capital turnover ratio of 33 percent. For every $1 of capital assets, the farm generates 33 cents. The ratio can vary from farm to farm depending on factors such as the price of land, the amount of land owned and the age of equipment.

As we can see from the illustration below, the historical (past) trend line is declining. Farms that make up the data set are, year-over-year, less able to generate gross revenue from the capital assets that are being used.

Capital investment is increasing at a rate that’s faster than the ability of farms to turn the investment into gross revenue. This won’t come as a surprise to most farmers. Still, the trend line illustration is troubling.

For it to “correct” and start to increase, capital investment would have to decrease or a farm’s ability to generate gross revenue would have to increase. Combinations of the two would also help.

Price and yield cause gross revenue to increase. Yields continue to increase and prices suffer from variability. Neither have been able to keep pace in the past 10 years. Will land, buildings and equipment become less expensive? This is literally the million-dollar question. Perhaps the most likely scenario would see the trend line level off.

However, another troubling aspect has to do with how the capital investment has been financed. The greater the amount of debt used to finance the capital investment, the greater the interest rate risk and the risk associated with principal repayment.

Overall, it’s not the best picture, but it is the reality within which farm families must manage.

Good financial information and a good understanding of a farm’s financial performance are starting points. Contingency plans are another good management practice.

It’s important to point out that the trend line in the illustration does not include increases in capital investment due to inflation. The investment included is at original cost less depreciation for buildings and equipment.

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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