In farm businesses, managers have to be both the general manager and the production manager. Since general managers are responsible for the overall financial health of the business, they need to focus on tracking those things in the business that lead to success – just as the Chief Financial Officer of a large corporation. There are three key financial performance measures for the CFO.
The first is profitability. Is the business profitable? Return on Assets (ROA) and Return on Equity (ROE) will be the most common measures to use. ROA measures returns to all farm capital. Farm capital excludes all of the farm owner’s personal assets. Typically, ROA will average above 9 percent on the best-managed farms. ROE measures the rate of return on a farmer’s own equity capital (net worth). From this perspective, the investment in a farm is just another asset in a farmer’s investment portfolio. ROE is an indicator of the performance of the debt capital component of a farm’s capital structure. ROE should be greater than ROA on a farm where debt capital is being used productively. Profit margin is the margin on sales available to compensate debt and equity capital. Asset turnover measures the dollars of gross sales or income generated each year ratioed to the total dollars invested as assets. Leverage refers to the amount of debt in the business.
Size is the second performance area. Is the business big enough? A couple key measures are the breakeven volume – that point at which enough revenue has been generated to cover costs. Viability is another aspect to consider. First, do returns from the business provide enough income to support the living expenses of the operators? Second, is the production of the business high enough to overcome market barriers to access? An example of this would a dairy farm in which the dairy cannot sell its high quality milk to the processor unless they are able to meet a certain minimum volume requirement.
The third area is growth. Can, and should, the business grow? Part of this is answered by the size discussion. The rest depends on the managerial capacity of the manager and the organization, and the availability of financial resources. As a business grows the leader of the business must acquire the skills of a general manager, and, at some point, they need to put down their production manager hat. A business can grow only with equity or debt based capital. And the amount of debt available depends on the equity. The rate of equity accumulation influences the growth rate. Equity can be accumulated only by making money (profitability) and saving money (retained earnings).
Framing Your Financial Picture is an OSU Extension program that explores these performance areas and helps farms measure them on their farm. This program will be held February 17, 2009 at 7:00 PM at Northwest State Community College, near Archbold, OH. Registration material can be found at http://defiance.osu.edu
Purdue Extension, Strategic Business Planning for Commercial Producers, was used in the development of this article with additional resources available at: http://www.agecon.purdue.edu/extension/sbpcp/