Knowing your farm’s rate or return on equity and assets is helpful in determining when to re-invest in the farm
A year ago, for this same Farm Finance issue of Grainews, I wrote an article encouraging grain farmers to update their net worth statement as soon as possible after harvest with current grain inventory, payables, receivables and so on. The idea is to get a clear snapshot of your financial position early and do a few simple financial ratio calculations in advance of heading into the planning and tax seasons of the year.
Of course, you still need to do an updated net worth statement at December 31 (or at your designated year-end) for your lender and for accrual adjustments, but preparing a draft statement early in the fall is an excellent management strategy to help you stay on top of your farm’s financial position. I again encourage you to do that work on your net worth statement now (check www.grainews.ca for back issues if you need some help).
In this article I will deal with another approach to determining how your farm business is performing financially and that is calculating the return on assets (ROA) and return on equity (ROE) of the farm. I find the rate of return numbers very interesting as they are easily compared to other industries and to opportunities other than the farm where you could invest your money such as a savings account, GICs, stock markets or other business investments.
Given the current financial turmoil in the world and low rates of return to many investments, we intuitively know that it’s not too hard these days for the rates of return to farming to be better, but that has not always been the case. As business managers considering future investment and re-investment in their farm businesses, I think farmers could benefit from knowing their own rate of return performance.
In order to calculate these rates of returns you need to do a couple of other calculations first: the “Value of Production” and “Net Income.” These can be calculated from your year-end accounting statements or accountant-prepared statements for any year or from your farm accounting records now for the current year (assuming they are up-to-date). To do these calculations now you also need to have your net worth statement updated, as mentioned above, with current inventories, payables and receivables as well as an estimate of any direct costs (expenses) expected between now and your year end. To keep things simpler here I am going to assume the farm is a straight grain operation.
Many will recognize that the VoP calculation (at right) is simply getting to an accrual based gross income number as the year-over-year change in inventory and accounts receivable can each be either a positive or negative number and are the accrual adjustments to cash income.
Return on assets
In any business, returns can be attributed to both the money invested in the business by the owners and the work that is “invested” in but not paid for by the business. That explains the theory of subtracting unpaid family labour in the formula but I seriously hope that in your farm business you are paying a reasonable amount to yourself and your family and that expense is already in your Net Income calculation.
As an example, using this formula (see above right), a $200,000 net income for a farm with $2.5 million equity would represent a ROE of eight per cent. For comparison purposes, I referred to David Kohl’s benchmarks for a farm’s ROE. These are: over seven per cent is good (green light), four per cent to seven per cent is cautionary (yellow light) and under four per cent is cause for concern (red light).
In the ROA formula above, interest is added back to net income as it is considered the return to your lenders money in the farm and therefore part of the return on assets.
Using the same example as above, if the farm’s net income plus interest was $290,000 and the value of the assets was $4 million, the ROA would be 6.4 per cent. Kohl’s benchmarks for ROA are: greater than five per cent is considered good/green, one to five per cent is cautionary/yellow and under one per cent is cause for concern/red.
Putting the ratios to work
I mentioned above that one way to use your rates of return figures, especially ROE is for comparison to other investment opportunities. Another is to compare the farm to itself in other years by charting the trend of ROE and ROA over a number of years, analyzing that trend and trying to explain any change in the trend or years that deviate from the trend line.
Another interesting insight from these return calculations is to compare the ROA you are achieving to the interest rate on borrowed money available to your farm. If your return on assets is higher than the borrowing rate it should theoretically mean you could borrow to acquire additional assets and, assuming you maintain the same ROA, achieve a return above the cost of the borrowed money. The caution of course is that this is only an interesting insight and not enough analysis to make a borrowing decision on.
A final word of caution: these rates of return calculations, and many other common financial ratios for that matter, are very dependent on the value you place on the assets on your net worth statement.
I hope you can get some time this winter to warm up your calculator and crunch some of these numbers for your farm. †