Measuring operational efficiencies
Dollars and Sense
GreenStone FCS | November 9, 2017
In today’s challenging economic times, it is more important than ever to monitor the operational efficiency of your operation. Paying close attention to imperative financial information can reveal the financial-health of your farm and identify possible options for improvement.
One of the simplest measurements to assess is your break-even point - when revenue fully covers costs. Most producers inherently sense whether they are breaking even by watching their working capital level and knowing whether they have enough money in the bank to pay all their bills each month.
An assessment of costs and revenues will provide deeper insight. When the data shows that break-even is not being met, the producer understands the need to reduce costs or increase revenues for the operation to be viable long-term.
Comparing your data to prior performance as well as industry benchmarks also provides great insight. On dairies, for example, this typically means analyzing three- to five-year trends in earnings, feed costs and labor costs, typically by hundredweight or cow.
To compare performance with industry standards, multiple resources exist, such as the peer comparison information GreenStone Farm Credit Services has compiled, several accountancies provide relevant regional data across a broad number of producers, and universities also offer benchmarking data.
It is important to be mindful when comparing your operation to others that the type of operation and its associated costs can vary greatly. For example, a dairy that buys feed and replacement cows will have a different cost structure than one that raises its own replacement cows and has ample pastureland. A grain producer who rents land will have different costs than one who has purchased land. A larger operation of any type likely benefits from economies of scale, particularly regarding labor costs per unit.
Another means to measure operational efficiency is analyzing your profit and loss (P&L) statement with accrual adjustment, which shows the sources of income and operating expenses.
Comparing P&L statements over time reveals how the operation is trending, as does analyzing several large expense categories in proportion to revenues. If you run a dairy operation, for example, feed purchases should total no more than one-third of revenue and labor no more than 10 percent of total revenue. For grain and similar cash-crop operations, no more than 25 percent of revenue should go to inputs such as seed and chemicals.
At a deeper analytical level, a series of key financial ratios offers significant insight. These ratios offer an objective assessment of an operation’s performance at a given point in time:
- Working capital, the difference between current assets and current liabilities, is the main measurement of liquidity. Producers should seek a 2:1 ratio of assets to liabilities.
- Working capital over revenue is another liquidity ratio, often with a goal of holding one-third of farm production value as current assets. If this level is not being achieved, the producer should find ways to increase inventories and reduce current liabilities, perhaps by working with a financing partner to consider options such as restructuring debt to stretch payments over a longer time.
- Equity-to-asset ratio is a solvency ratio, which measures how much equity, or net worth, a producer has in relation to assets. For every $100 in assets, an operation should have $50 in equity or 50 percent. A lower ratio often indicates the assets are borrowed against, and producers in this situation should likely focus on repaying debt or liquidating assets.
- Rate of return on farm assets measures your operation’s profitability, which should be at least at or above the interest rate earned on a typical savings account. In today’s low-interest rate environment, any rate greater than 4 percent is positive for the producer. If the percentage is less than this, the producer should focus on generating more profitability by increasing margins or selling off non-performing assets and either paying down debt or investing in assets that will generate more profitability.
- Rate of return on farm equity is another profitability measure and is more common for producers seeking investors into their operation. It can also provide decision-making support – if this rate is lower than desired, again the solution is to increase the profit margin and/or reduce the debt load.
- Asset turnover ratio is one way to measure financial efficiency by measuring an asset’s ability to generate revenue. While the ideal is a 1:1 ratio in an asset’s first year, (meaning that every dollar invested in an asset generates a dollar in revenue) it is extremely rare in agriculture. A more realistic target for producers is a 30-cent or 40-cent return on each dollar invested; operational decisions such as renting land rather than purchasing it as an asset can improve this ratio if needed.
- Operating expense ratio demonstrates operating expenses in relation to the revenue generated. If, for example, an operation generates $100 in revenue and only spends $10 on operating expenses, it has a 90 percent operating efficiency. For agriculture, a level of 65 – 75 percent is acceptable. If an operation’s ratio is not at this favorable level, the first solution is to reduce operating expenses, but if costs have been cut as far as possible, working to generate more revenue at the same cost level will be key, either by increasing productivity, marketing for a better price or selling more units.
- Repayment capacity is a critical measurement for lenders, as it conveys a borrower’s ability to repay their loans. Typically, a 1:1 ratio is acceptable, meaning that the producer is generating exactly enough revenue to repay their debts; however, a better goal is ratio of 1.15 – 1.25, which indicates that the producer is generating excess revenue that can be added to working capital or invested in strong performing assets.
Reviewing your critical financial data is an ongoing responsibility for sound operational management. Look for a financial partner who will sit down with you on a quarterly, or even monthly basis, depending on your operation, to drill down on the relevant data points.