Outlook

Economic efficiency in the reset

A drive toward economic and financial efficiency is a rally call for businesses inside and outside of agriculture.

A drive toward economic and financial efficiency is a rally call for businesses inside and outside of agriculture. One metric used to measure financial efficiency is the operating expense to revenue ratio. This ratio is calculated by deducting depreciation and interest paid from total business expenses; and then, dividing that subtotal into total business revenue. Simply put, the ratio measures how much it costs the business to generate one dollar’s worth of revenue, regardless of borrowed money or the method of depreciation.

Previously, we discussed measurements of repayment ability through the term debt coverage ratio; and profitability as measured by return on asset or ROA. Both ratios are analyzed by University of Minnesota’s Center for Farm Financial Management using their Farm Financial Database (FINBIN). This database contains accrual adjusted data, which this makes the analysis and summaries more accurate than if based on tax information. Of course, the same is true for a business as well. 

The top 20 percent of profitable farm businesses in this database had an average operating expense to revenue ratio of 74 percent.That is, it costs these farm businesses $.74 to generate $1.00 of revenue. That leaves only $0.26 per dollar to address living costs, debt servicing, taxes, and capital replacements. These results are similar to the data from the previous four years. However, when compared to the stellar years of 2006 to 2012, the difference is glaring.  During that time, for the most profitable operations, the average operating expense revenue ratio was 64 percent, nearly 10 percent more margin. Much of the industry’s growth came from this group who used their margin to purchase and finance assets or expansion.

Looking at those farm businesses in the average category, they required $0.83 to generate $1.00 of revenue, excluding interest and depreciation. Of course, this leaves a meager $0.17.  Again, this was in line with the previous four years of the economic reset. In contrast, the “go-go” years of the supercycle averaged $0.70. As compared to the other segments, the average group lost more in financial efficiency, and has not been able to adapt as quickly to today’s modified economics. 

Farms in the lower 20 percent of profitability required a whopping $0.96 to generate $1.00 of revenue (excluding interest and depreciation). Thus far in the economic reset, this group has averaged only a 2 percent margin, exhibiting considerable financial stress. However, during the supercycle years, this group still required $0.90 to make $1.00. 

What does this quick analysis illustrate? Top-level managers are being more proactive in making adjustments in production, marketing, and cost controls, which directly impacts the bottom line. Aptly called an economic reset, this type of cycle demands any successful business to “reset” its numbers through economic and financial efficiency.

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