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Grade your financial and business performance

Progressive Dairyman Editor Karen Lee Published on 31 December 2014

Students across the country are receiving their midterm report cards. When was the last time you received a grade for your performance?

In a webinar hosted by the Professional Dairy Producers of Wisconsin, Dr. David Kohl, professor emeritus, Agricultural and Applied Economics at Virginia Tech, provided a format farm businesses can use to measure their financial and management performance.

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“Profitability is not an option; it is a requirement,” Kohl said before he outlined the seven factors he likes to concentrate on when analyzing the financial side of the business.

1. Return on assets
Kohl said he prefers to look at return on assets as opposed to return on equity. According to FINBIN data based on thousands of farms’ financial information, the top 20 percent of farms – whether livestock, crop or a combination – have a rate of return on assets at 10 percent or greater, he said. The bottom 20 percent of farms were at 1 percent or even negative.

When calculating the rate of return on assets, this economist prefers using cost value as opposed to market value. That way if your return is greater than the rate of inflation, you are developing real wealth as opposed to the capital wealth that comes from a rise in market value, also known as paper wealth.

A higher return on assets may result in higher income taxes. “Most businesses do not go broke paying income tax, but they do go broke minimizing income tax, trying to buy unproductive assets just to reduce taxes,” Kohl said. “I think in the next few years, it is going to be a balance of profitability, paying taxes and building working capital.”

2. Operating efficiency
“Better is better, before bigger is better,” he said. “Get efficient before you get bigger.” To find the margin, take revenue minus expenses (excluding interest and depreciation) divided by revenue. A strong business will have a 25 to 30 percent margin. The important thing to remember is to not just look at one year, he said; three years is better.

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“You need to know how much it is costing you to generate a dollar’s worth of income,” Kohl said. “I exclude depreciation and interest because some farms aren’t carrying any debt, and we don’t like to penalize the farms that are carrying debt. Also because we all play games with depreciation.”

3. Asset turnover
“This is the biggest strategic weakness of the grain industry,” he said. “High prices cure high prices; if you bid up the land, you squeeze the profits out.”

However, a good manager – regardless of a large farm or small farm – knows how to turn their assets. Combined with a good margin, it is commonly referred to as earns and turns. By improving both margin and asset turnover, a farm will improve its rate of return on assets.

4. Total debt to EBITDA (earnings before interest, taxes, depreciation and amortization)
Kohl said he is seeing more lending institutions starting to look at this new metric. An example is to say a farm has a total debt of $1 million and its EBITDA is $200,000; the ratio is 5-to-1.

“This ratio is very important, particularly if your debt is amortized over a 10, 15, 20-year period,” he said. “It’s not all about paying the debt back in 2014 or 2015, but all the way through the cycles to 2025.”

A ratio less than 3.5-to-1 could be viewed as a green light. From 3.5- up to 6- or 7-to-1, you’re in the yellow. When you get to 7-, 8-, 9- or 10-to-1 for multiple years, it shows there is too much total debt for the ability of the business to generate earnings.

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He cautioned to be careful when milk prices are strong because it could make debt-to-EBITDA ratios very favorable. Instead, average the number over a two- to five-year period.

5. Working capital to revenue
With more volatility in the marketplace, a value growing in importance is working capital.

“I don’t like to use the old current ratio, which lenders often use, because as the business starts getting bigger, it is not quite as applicable,” Kohl said.

Referencing FINBIN data, the top 20 percent of producers are above 53 percent, and the lower 20 percent of producers are 13 percent or under.

He suggested keeping working capital to revenue above 33 percent would be a green light; 10 to 33 percent would be a yellow light and less than 10 percent would be a red light.

6. Percent equity or debt to equity
“The first thing I look at when I pick up a balance sheet is percent equity,” Kohl said. “This one really talks to you. It basically says what percent of the business do we own and what percent do the lenders own.”

He reported the typical commercial dairy farm will be right around 60 percent equity, but suggested producers not get too hung up on this ratio.

“If you are under 50 percent equity, it doesn’t mean it’s a red flag,” he said. “If you go down to 40 or 30 percent equity, that’s when you have to have offsetting diagnostics. That’s when you’re going to have to have strong working capital and have to be strong with profitability. You’re also going to have to be strong in just your overall management.”

Young farmers can expect to be in the 30 to 50 percent range and will have to be much stronger in the other components.

Like a typical report card, one bad grade doesn’t signify a bad student; it’s all about balance, he said.

7. Coverage ratio
This metric is of great interest to lenders. For an example, if you have $200,000 of debt service ability and your payments are $100,000 annually, you have a 2-1 ratio.

Looking at FINBIN data, the top 20 percent have been 3-, 4- or 5-to-1, whereas the bottom 20 percent are under 100 percent. Strong equity and the ability to refinance help the lower portion stay in business.

However, as commodity prices on the grain side weaken, Kohl said even the top 20 percent are now down around 200 percent. He suggested keeping this value greater than 140 percent will provide the necessary cushion during volatile times.

Again, Kohl said it is important to not focus on a single year when diagnosing the financial status of a farm, but to look at a trend analysis to see the direction the farm is going.

“You should also do projections and look at the best, average and worst-case scenario,” he said. In the worst-case scenario, look at a drop in milk prices or a rise in feed cost, and see how it impacts the financial standing of the business.

“This tool is not only for communicating with your lender, but it is to communicate with the management team or the son or daughter that’s coming back to the business,” Kohl said.

Management analysis
Financial metrics are not the only subject a farm should be graded on in terms of performance. Kohl said in working with Dr. Danny Klinefelter of Texas A&M University, they often find financial performance is a factor of management performance. Therefore, he recommended analyzing areas related to the farm’s management as well.

  • Do you know your cost of production by enterprise? It is good to know the cost of production for the overall operation and also for each of the various components in the operation. When people know their enterprise, what is making them money and what is losing them money, that can really be a management aspect that often times leads to better performance, Kohl said.
  • Is there a written marketing plan not only for selling goods, but also for purchasing inputs?
  • Do you have a written business plan? “It doesn’t have to be a big, thick document,” Kohl said. “Some of the best business plans are five to seven pages long.”
  • Are you executing your goals? “I find a lot of people are really good strategists, but they don’t execute, they don’t follow through, they don’t monitor and they don’t evolve their business,” Kohl said. “That is one of the things that is really showing a dividing line between the ones that make it and the ones that don’t.”
  • Is there a transition plan in place? Kohl learned lenders are starting to ask if producers have a one-page write-up for how they plan to transition their business. He was not referring to an estate plan, but a transition plan that outlines how you will develop the next level of farm managers.

“If you don’t develop that next level of managers, often times the business can go upside down very, very quickly,” he said.

  • Do you utilize an advisory team? This team comprised of a lender, livestock experts and crop experts should meet occasionally – quarterly or semi-annually – to discuss the business.
  • Is there a risk management plan? Not necessarily a marketing or hedging plan, but whether or not the farm has adequate insurance coverage and wills in place for the ownership team.
  • Do you have a training program?

“If you don’t take advantage of educational programs, you’re falling behind,” Kohl said. “Sending your employees [to educational programs] and having a training program listed out is very, very critical.”

  • Does the farm have an environmental conservation plan?
  • Is there a written lease or ownership of at least 75 percent of the land and other assets? “This is very critical for dairies, particularly with all the competition for land,” he said.

Credit score
The last subject to receive a grade is your credit score. Lenders are looking at credit scores and even deeper at the entire credit report. Not just for the owners, but also for their spouses. “This is a sign of character, and character is very, very important,” Kohl said. He recommended credit reports be reviewed for all major partners each year. The number to hit is 700 or above.

“This dairy business is vastly evolving,” Kohl said. “This could be a fun [analysis] to sit down with your advisory team and have them fill it out on you and then you fill it out on yourself.”

Will your report card be one to be proud of, or will you be trying to be the first to the mailbox to hide any poor performance? PD

Hear more from Dr. David Kohl in this related article: "10 practices for a top-performing dairy CEO."

karen lee

Karen Lee
Editor
Progressive Dairyman

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