The recent Farmland Values Report issued by Farm Credit Canada doesn’t tell us anything we don’t know: farms are getting bigger and have been for quite some time.
The report is interesting, to say the least. Trying to give perspective and determining what to do with it requires further information.
Will farms continue to become larger? I think most people would think so but we don’t know what the future will bring. To gain an understanding of the financial implications of growth in farm size, any farm can use historical financial information to gain perspective on data in the report.
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Out of curiosity, I looked at the financial data for a real farm for the period 2012-21. The farm fits into the 5,000 to 10,000 acreage category. There wasn’t much change in its acreage in the 10-year period.
I looked at two financial performance indicators: gross margin efficiency and operating efficiency.
Gross margin efficiency is calculated by subtracting direct production expenses from gross revenue to arrive at gross margin, and then dividing the gross margin by gross revenue. It indicates how efficient a farm is at using its production expenses (seed, fertilizer, chemical, crop insurance) to generate a margin of profit. A general guideline is 65 percent, or with gross revenue of $1 million, a gross margin of $650,000.
Earnings before interest, taxes, depreciation/amortization (EBITDA) is a margin of profit before any depreciation or interest costs are included. EBITDA is converted to a ratio when it’s divided by gross revenue, which is called the operating efficiency ratio.
It indicates how efficient a farm is at using all its expenses (other than interest and depreciation) in generating gross revenue. A general guideline is 35 percent, or with gross revenue of $1 million, an EBITDA of $350,000.
The farm’s financial performance over 10 years was significantly variable. Gross revenue per acre ranged from a low of $166 to a high of $385. Gross margin efficiency ranged from a low of 42.4 percent to a high of 79.2 percent. EBITDA ranged from a low of $6 to a high of $215 per acre.
The farm in question had a highly profitable year in 2021. But for this farm, 2016 was even more profitable based on margins and ratios. Operating efficiency in 2016 was 57.7 percent compared to 55.6 percent in 2021.
Is this significant? Not really, if you were to look at the EBITDA values. There was less than a $10,000 difference from 2016 to 2021.
What is significant, in my opinion, is the financial efficiency performance expressed as a function of land values. Farmers capitalize profit — always have and likely always will. The value of farmland per acre (based on reported sales in the area in which this farm is located) increased 1.8 times from 2012 to 2016 and then another 2.4 times from 2016 to 2021.
Increasing land values are a good outcome if you own land. This particular farm’s net worth increased 1.5 times from 2012 to 2016 and another 1.7 times between 2016 and 2021.
Further, this farm had three years with exceptional financial performance — 2016, 2020 and 2021.
When I look at the farm’s performance and factor out those highly profitable years, the performance weakens considerably. Gross margin performance over a seven-year period was 52.3 percent and operating efficiency was 15.2 percent.
What does all this mean? It depends on the amount of leverage or debt on the farm. It would be worrisome if the farm was carrying a significant amount of debt.
It also depends on the farm’s appetite for growth because if the growth comes from increasing the amount of owned land, there will be an increase in debt.
And it comes back to the reality that farms tend to capitalize profit. As long as financial efficiency margins stay high (resulting in higher profit), then carrying higher levels of debt is not as much of a concern.
But as efficiency margins erode, so do profit margins. Profit margins turn into cash. Eroding margins equal less profit equals less cash for re-investment and for making payments on existing debt, which is not a pattern any farm wants to have.
NASCAR announcers start a race with “start your engines.” Certainly, the business of farming is not a race. Having said that, it would be a good practice to “watch your margins.”
Terry Betker, PAg, is a farm management consultant based in Winnipeg. He can be reached at 204-782-8200 or terry.betker@backswath.com.
