By David Beca, RED SKY Agricultural Pty Ltd
WHAT IS PROFIT?
Gaining a return on the capital you have invested in your farm business is one of the primary reasons for owning the assets. Whether the assets include land, livestock, vehicles, machinery, or other assets, there is a need for you to receive a return against these. With land in particular it is likely that a proportion of any return will be received over time as a lift in capital values. So when calculating profit it is important you know your level of profit when changes in capital values are both included and excluded.
But firstly it is important to understand that calculating the return you are receiving on the capital invested in your business is to calculate profit. As a result your key profit ratios must refer to a unit of capital. Return on Assets is the best measure of profit as it calculates your return against the value of all the assets you own. A ratio that refers to your land (e.g. Operating Profit per Hectare) will not be as accurate a measure of profit as Return on Assets, although at least it refers to your major capital asset. If you are a sharemilker or sharefarmer then your best measures of profit after Return on Assets could be Per Cow or Per Ewe ratios as your livestock are your major capital asset.
Ratios that refer to milk, beef, lamb, wool or other product are not indicating the level of profit in a farm business but are calculating the RISK in your business.
WHAT IS RISK?
Understanding how quickly your profit can either increase or decrease due to changes in your trading conditions is an important factor in managing your farm business. For instance knowing the effect of any change in milk price or other product price, feed price or interest rate on your level of profit is to understand the degree of risk in your business.
The most important measures of risk calculate the proportion of each dollar you earn or each kilogram of milk or other product you produce that you keep as profit. For instance the best risk ratio is called Operating Profit Margin which refers to the percentage of each dollar you earn that you keep as profit. A 25% Operating Profit Margin means that you keep 25 cents in each dollar of revenue, from which you then need to service any debt and pay tax.
WHAT IS SOLVENCY?
It is important as a business operator that you are confident you can meet all your obligations as they fall due. Ratios that record the likelihood of you being able to do this measure your solvency. Even during periods of low milk price (or other product price) and low profit when it may be difficult to maintain a strong cash flow, the most important factor is that you can raise further funds should the need arise.
As a result the most important solvency ratio is the percentage of equity you have in your business. This also records the proportionate value of the assets under your control that you would retain should you decide to sell your business.
WHAT IS EFFICIENCY?
There are a wide number of factors that impact on your level of profit. To maximise profit you will need to be strong in a number of areas that cumulatively impact on the performance of your business. Efficiency ratios record levels of performance in these areas, where each area on its own may not lead to an improvement in profit if it is focused on to the detriment of others.
Two major areas of expense that impacts heavily on profit relate to the cost of feed (including pasture) and of labour (both paid and “unpaid”). As a result you need to know the full cost of pasture to your business, as well as the full cost of forages and concentrates if these are fed. In addition you need to know the number of cows or ewes or other livestock that are being managed by each standardised staff equivalent (regardless of the level of individual animal performance).
It is critical to the future success of your business that you find measures that record your level of profit, risk, solvency and efficiency. In addition you must monitor your cash flow closely which will determine your level of LIQUIDITY.
You do not need to have large numbers of ratios to fully record your business performance but as the different categories of ratios highlight, you will certainly need up to a dozen ratios to describe your business. You also need to understand what factors impact on these ratios so that you can make positive change in your business.
Some of this change can be prompted by comparing your own performance with your peers, especially other farmers who are performing at a high level. Other opportunities for change can be determined by recording your progress over time and then using this analysis as a spring-board to developing an improved budget and farm business plan.
The key ratios I use when analysing a business include:
THE “FIRST FIVE” of KPI’s (Key Performance Indicators)
(* this measure calculates the effective nett cost of producing each kilogram of product with debt servicing and tax the only further costs not included)
ROUNDING OUT THE “FIRST ELEVEN” of KPI’s
THE “TWELTH MAN” of KPI’s