Return on Assets

ROA (Return on Assets)

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Return on assets, or “ROA” as we’ll refer to it, is an often overlooked financial metric on the farm. Partly, I think it is because there is a culture in agriculture that places too much emphasis, even “romanticizes” the accumulation of assets (namely land, but mostly equipment.) This doesn’t necessarily bode well for ROA calculations. But the greater reason ROA isn’t a regular discussion on the farm, in my experience, is because it is not understood.

return on assets formula

The math is simple to understand, so when I say “ROA is not understood,” I mean that the significance of ROA, and its impact, is not appreciated.

Return on Assets is a profitability measure. Its key drivers are operating profit margin and the “asset turnover ratio.” ROA should be greater than the cost of borrowed capital.

Let’s ask the question: “When calculating ROA, do we use market value or cost basis of assets in the denominator?” The simple answer is “BOTH!”
Do two calculations:
1) using “cost” to measure actual operational performance;
2) using market value to measure “opportunity analysis” which is a nice way of saying “could you invest in other assets that might generate a better return than your farm assets?”

Operating profit margin is calculated as net farm income divided gross farm revenue, and is a key driver of Return on Assets.

The asset turnover ratio (also a key driver of ROA) measures how efficiently a business’ assets are being used to generate revenue. It is calculated as total revenue divided by total assets. The crux of this measurement is that it has a way of showing the downside of asset accumulation. The results of this calculation illustrate how many dollars in revenue your business generates for every dollar invested in assets. While there is no clear benchmark for this metric, I’ve heard farm advisors with over 3 decades experience share figures that range from 0.25 to 0.50. This means that for every dollar of investment in assets, the business generates 25-50 cents of revenue (NOTE, that is REVENUE not PROFIT).

If assets increase and revenue does not, the asset turnover figure trends negatively.
If revenue increases and profit does not, the operating profit margin trends negatively.
Increasing revenue alone will not positively affect ROA. “Getting bigger” or “producing more” alone without increasing profit does not make a difference. If you recall: “Better is better before bigger is better…”

To Plan for Prosperity

As you will find in many of these regular commentaries, the financial measurements described within are each but one of many practical tools to be used in the analysis of your business. Return on Assets cannot be used on its own to determine the strength or weakness of your operation. But used in combination with other key metrics, we can determine where the hot issues are, and how to fix them so that your business can maximize efficiency, cash flow, and profitability.

Per Acre Equipment Investment

Per Acre Equipment Calculation

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In the June 8, 2017 edition of the Western Producer, columnist Kevin Hursh penned Per acre equipment calculation can be revealing. As is typical, Hursh hits the nail on the head with this piece by suggesting farms should know their equipment investment per acre. His column goes on to describe how new equipment has seen significant increases in SRP (suggester retail price) over the last few years, contributing greatly to the elevating of the “per acre equipment calculation.”

First, let’s figure out where you are at. Add up the current value of all your equipment, owned and leased. If that total is $2.5million, and if your farm is 5,000 acres, your equipment investment per acre is $500. If we compare that to a 2,500 acre farm with $1million invested in equipment (therefore $400/ac), who is better off?

Measure it against earnings

Last year, I had a client tell me about a meeting with his lender. This particular client is small acreage, relatively speaking (under 1,000ac in crop) and yet was quite well equipped for his acres. He carried minimal debt, and despite some cash flow challenges over the previous two years, his working capital was still very strong. He was seeking a high-clearance sprayer so that he could ensure timely fungicide applications for his lentils, and other high value crops. The feedback he received from his lender was that his “equipment investment per acre was to high.” On the basis of that single calculation, it most certainly was. What the lender failed to evaluate was the entire farm profitability. Because of the small acre base, my client was able to produce a rotation of high-management high value crops. His net profit per acre was almost double a typical grain farm. His ability to justify a high equipment investment per acre was evident. Needless to say, he acquired his sprayer (a used model valued at just north of $100,000) pushing is equipment investment per acre from $484 to $644.

Let’s go back to the 2 fictional examples above.
EBITDA vs Per Acre Eq InvIf we only looked at equipment investment per acre, we would likely conclude that Farm B is in a better situation by only having $400/ac invested in equipment versus Farm A having $500/ac. Yet when we dig further by bringing EBITDA into the calculation (EBITDA is Earnings Before Interest Taxes Depreciation & Amortization) we discover that Farm A generates stronger EBITDA per acre than Farm B, and is therefore possibly justified in having a higher investment per acre in equipment. In practical applications, even this doesn’t go far enough to determine which is better, but it’s a start.

To Plan for Prosperity

Delving into management calculations can be daunting and confusing. If we don’t know what to look for, how it compares, or even if we’re not measuring anything, we’re already behind before getting started. Begin by measuring the many facets of your business; in this case, “What is your equipment investment per acre?” How has is changed over the last five to ten years?

Relating back to my client, his EBITDA was a whisker under $120/ac, so his EBITDA to Equipment Investment on a per acre basis was about 0.186:1. This means that with his equipment investment of $644/ac will generate about $0.186/ac in EBITDA. Is that a good metric? As Kevin Hursh closed his column, “It’s unfortunate that more information isn’t available on the typical investment levels in each region. That would allow producers to make more relevant comparisons.”

Canola 100 fail title

Why the Canola 100 Challenge is So Wrong

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Announced two years ago around this time, the Canola 100 challenge baits farmers into taking part in a “moonshot”: an attempt to produce a verified canola yield of 100 bushels per acre. It isn’t that efforts to increase yield aren’t a good thing, because they are. But by what means are we attempting to achieve these yields?

This “contest” may be virtuous in spirit, but it overlooks the not-so-old adage that “better is better before bigger is better.” That applies to this argument too.

The rationale behind my position is supported in this Western Producer article that describes a farmer’s chase of this moonshot, throwing everything including the kitchen sink at his crop in an attempt to cash in on the Canola 100 prize. (Spoiler alert: it failed miserably.) This particular attempt can be summarized in this quote from the article:

The fertility program cost $300 per acre more than what was done to the check field but yielded only 70 bu. per acre, which was 1.4 bu. per acre more than the check field.

The driving factor behind efforts to maximize yields should be ROI (Return on Investment) and Gross Margin. Doing so would focus on maximum economic yield, not maximum production yield. There’s something about that pesky law of diminishing returns that gets overlooked when trying to shoot for the moon…

If maximum economic yield is the target, then Gross Margin is the focus. How that gross margin is achieved is up to each producer, but make no mistake about where the focus needs to be. In my experience, minimum gross margin, that is gross revenue less seed, chemicals, and fertilizers, at MINIMUM needs to be 65% to sustain the business. High cost operations need greater gross margin to cover all those costs.

To put that in reverse, if 35% of your gross revenue can go to crop inputs, then each $1.00 invested into inputs should return $2.86 in gross revenue. To apply this to the example above, the “extra $300 per acre” in fertility should have delivered $858/ac in gross revenue. If Canola was $10/bu, that’s nearly 86 bushels per acre above the check field.

Canola 100 fail

Let’s push the argument harder: if the example above actually hit 100 bushels per acre, and acknowledging the control field yielded 68.6 bu/ac, the gross margin on the Canola 100 plot was $14 per acre, or about 4.67%.

This is IF the 100 bushel yield was achieved…and face it, $14 gross margin doesn’t pay many bills; in fact, it wouldn’t even buy the fuel for the contest plot.

To Plan for Prosperity

Make no mistake about the messaging here: as a producer of commodities, you need the bushels!!! But do not lose sight of the fact that as a producer of commodities, your only chance of remaining sustainably profitable is to produce at the lowest cost per unit. Period. Chasing maximum yield at a 1:1 ROI won’t get it done.

1. What is your historical gross margin?
2. What are your operating and overhead costs?
3. Know these to be able to plan for maximum economic yield.

 

Focus

Results Focused or Activity Focused

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Most farms will be receiving their year end financial statements from their accountants by now, if not already. Those with fiscal year ends of January 31 or later might still be waiting for their year end to be finalized.

How did your last fiscal year turn out? What were your financial results? If you are results focused, you’ll be paying attention to metrics like:

  • Net Profit
  • EBITDA
  • Gross Margin
  • Return on Equity

Activity focused operations typically don’t review financial reporting, instead directing energy towards:

  • Greasing
  • Shoveling
  • Driving
  • Anything else…

To Plan for Prosperity

There are some who will say that “money and profit aren’t everything.” Don’t listen to them. They aren’t focused on results. Yes, health and family are more important than money because money cannot buy health or a happy family, BUT without profit no one will be happy.

Profit is the fuel for your business. And like the diesel in your tractor, if you’re not making sure you have enough, things are going to stall.

Average

Don’t Settle For Average

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It was the headline that struck me.

Don't settle for average _embedded

Settling for average in any aspect of your business will lead to certain demise. If everything was average (yields, quality, market prices, rainfall, heat units, weed pressure, disease pressure, input prices, equipment repair frequency, wages, overhead, etc, etc, etc…you get the picture) then farming would be easy.

But it’s not.

Fair to say that if you are projecting average yields and prices for 2017 you’ll be measuring those against higher-than-average costs. This is likely to total down to a negative bottom line.

I’ve never been a fan of “average.” As my old friend Moe Russell likes to say, “You can drown in a river that averages a foot deep.”

Average, to me, is nothing more than a feel good guide when looking to validate poor results. For example, acknowledging that yields were only a couple bushels below average means nothing Table for Averagewithout quantifiers like market prices (meaning we’ve calculated gross revenue), like input cost (meaning we’ve calculated gross margin), or like operating costs (meaning we’ve calculated profits from operations.) Here is a table to illustrate what I’m getting at:

If average is profitable over the long term, then we must acknowledge the need to adjust all facets of our profit calculation when one facet is below average. The problem is that generally we are seeing farms operate with higher than “average” costs and trying to pay for them with “average” yields.

To Plan for Prosperity

Our profitability is not determined by where it falls on a bell-curve, so why would we accept “average?”

 

scoreboard

Scoreboard

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We’ve just come out of an age where keeping score didn’t matter. Everyone got a participation ribbon. No one’s feelings got hurt. Maybe we’re still in this age, I don’t know.

Why do we want to keep score? “Because we want to win” is a good answer. But what if we’re not competing against an opponent, what then?

Keeping score is a form of measurement. Whether you’re measuring progress or efficiency, minimum standards or ultimate goals, a measurement is required. In your business, you’ll find the most critical financial measurements in your financial statements.

I’m not much of a golfer, but I do enjoy the game. While I don’t get out nearly often enough, when I do, I always keep score. My playing partners occasionally don’t care to keep their score, and that’s just fine. I’m not playing to compete against them; I’m competing against myself. I know how good I can play, and each round I strive to match that, and maybe get a little better. For the record, I’m about a 15 handicap; I am looking forward to the day I break 90.

You may not view your business as having competition that you need to “outscore.” But when it comes to finite resources like land and labor, make no mistake you are in competition and whoever is leading on the scoreboard is most likely to win the prize.

The scoreboard in sports shows who has most points. The scoreboard in Monopoly is simply who owns the most property and hoards the most cash. The scoreboard is what you make it, but it is worthless if you don’t use it (and check it once in a while…)

To Plan for Prosperity

Run your farm like a business, and it makes a great lifestyle.

Run your farm like a lifestyle, and it makes a terrible business.

If I knew who said it first, I could offer attribution. The analogy then is if you don’t want to keep score, are you happy with a participation ribbon?

ThinkingMan

Thinking Time

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This is following through on something I sort of dared myself to do in a tweet recently:

Thinking Time

I smiled at Danny’s tweet about about the lack of bites while ice-fishing and how it was contributing to crop plan changes for this spring’s upcoming seeding season (or “planting season” as it is also called.)

Thinking time is something that we seem to have less and less of these days. With the constant bombardment from numerous social media platforms, phone calls, text messages, and emails, it is amazing we are able to get anything done. Quiet time, disconnected from our “devices” is not only critical to staying sane (disclaimer: I am not a psychologist and that is not a psychological prescription) it is also required for some thinking time.

Consider the many aspects of your business, and the thousands of decisions you make every day. This doesn’t even touch on the “major” business decisions that need to get made through the course of the year. Many of those daily decisions are reactionary because the situation is something you’ve been through many times before, or you may have prepare for the decision with some planning. Other situations require that you stop what you’re doing to make the decision, whether that be from the situation being something you’ve never dealt with before, or possibly because you just hadn’t considered it and you’re therefore not prepared.

For me, thinking time happens all too frequently; it’s just how my mind is (always grinding away on something.) The challenge for me is that if I’m not prepared to record or act upon (what i think is) a brilliant thought or idea, it can get lost. It’s been suggested that I keep a note pad or recording device with me all the time. A great theory that is tough to enact when I”m driving, or when I’m laying awake in bed trying so hard to fall asleep; both are situations when my quiet time, my thinking time, seems strongest.

My new strategy is to dedicate a portion of each day to thinking time. It’s not scheduled, nor is it rigid in practice. I allow myself the time, possibly a few times each day, to do the creative thinking I need to do in my business when the juices begin to flow. This allows me to take notes of my brainstorming, to elevate my confidence in that I have captured what are (in my mind) brilliant thoughts and ideas, and reduces angst over the “I had a great idea on _____________, and I lost it!” <insert curse words here>

When I was farming, some of the best opportunity for thinking time was in the tractor; I’m sure it’s the same for many of you. The problem is that thinking time in the tractor while seeding is too late to be crop planning. Although, it is a terrific time to give thought to your financial reporting from the previous year and tactics to improve for the current year.

To Plan for Prosperity

There is an almost immeasurable amount of information coming at us from the virtual world and from the plethora of farm shows scheduled across the prairies all winter. To sort out all of the information available to you, and not be overwhelmed in the process:

  1. Set aside some designated thinking time on a regular basis (unplugged, no devices, no distractions;)
  2. Enlist the guidance of advisors who experts in their field;
  3. Give yourself the leeway to make mistakes. Perfection is unattainable.

Thinking time should not be limited to current issues or the next three months. Also include the next three years. Your business is an ocean freighter, not a speed boat; changing course and making adjustments cannot happen quickly, they take time and deliberate action.

dashboard view

Dashboard

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What’s on your dashboard?

If you’re thinking about your trucks & tractors, the answer might be anything from gloves to a coffee mug to a clip for the rifle.

What I mean is “what are you watching on your dashboard?”Truck Dashbaord

  • Oil pressure?
  • Coolant temperature?
  • Exhaust temperature?
  • Seeding Rate?

All of these are important, and no doubt they all get significant amounts of your attention.

What are the consequences if any of these go into the RED?

 

What about your BUSINESS dashboard?

  • Working Capital?Financial Dashboard
  • Debt:Asset or Debt:Equity Ratio?
  • Unit Cost of Production?
  • Gross Margin?

What are the consequences if any of these go into the RED?

 

Which set of gauges get most of your attention? A failure on which set would be catastrophic?

When I was still farming, the first day of seeding in 2014 had one of these go into the red, only I didn’t know it because the gauge failed. In short, the tractor needed an engine overhaul because of severe overheating. Did it break the farm? No. Did it make seeding extra costly, and take longer than otherwise would? Yes. Did we survive? You betcha.

To Plan for Prosperity

We tend to do what we do best, what we like to do, and what we understand. Understanding the safe range, the limits, and the consequences of oil pressure or coolant temperature running into the red is something that is ingrained into us as youngsters who were imploring that we be able to run equipment. Yet, if no one teaches business owners the safe range, the limits, and the consequences of running their working capital or gross margin “into the red,” how will they know what to watch, or to watch at all?

For an intensive strategy on setting up and monitoring your business dashboard, call or email me anytime.

iconic backstop

Backstop

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What’s your backstop?

Recently, I read an article from some economist on interest rates. The premise was that interest rates have to rise in the short term, even though the economic signals aren’t yet supportive of an interest rate increase. The rationale: if the economy hits another pothole, and rates have remained at their historic lows, then there is little in the way of monetary policy options available to kick-start the economy. In other words, if rates stay low and the Bank of Canada (or the US Federal Reserve for that matter) needs to reduce rates to stimulate spending, how can they reduce rates that have no more room to go down? Do we toy with the idea of negative interest rates? It appears we have no backstop.

The challenge now is how to prepare for a potential future trouble spot when there is presently no wiggle room. To increase rates now will all but guarantee that our fragile economy will stumble. By not raising rates now leaves no room to reduce rates in the future (if needed) and all but guarantees that a potential trouble spot will be far more than a spot, it would be a huge stain. Damned if you do, damned if you don’t. I do not envy Governor Stephan Poloz’s job at all…

Does it seem as though there was too much confidence from policymakers, thinking like it can’t happen to me? Some might say that the policymakers didn’t want to to what it took to prevent fire and now may have to fight fire.

This thinking can also apply to child rearing. Kids who typically get what they want, especially after whining, usually fall into tantrums when parents offer a firm “No.” Without laying a baseline for what is acceptable and tolerable behavior from their children, tantrums ensue. In other words, the parents have left themselves with no backstop.

An effective backstop for your business can apply to many different facets: personnel, equipment, agronomic, risk management, etc. From the financial perspective, your backstop should be made up of several key pieces:

  1. Working Capital (especially cash)
    Strong working capital solves many problems, and prevents even more. It reduces cash flow risk, takes significant pressure off of market risk, and best of all it creates growth opportunities.
  2. Equity (and its relation to debt)
    If your business is weak in working capital and strong in equity, these low interest rates offer the best opportunity to recapitalize your farm. On the other hand, I smiled at a comment made by a client late in 2016 when he was postulating how fun and profitable farming would be without burdensome debt obligation weighing (him) down and pressuring (his) cash flow.
  3. Management Strength and Discipline
    Too often I’ve seen farm businesses that were strong in working capital and equity whittle away at their backstop to satisfy their expansion desires. Strength and discipline is required to not get caught up in the euphoria of more and more assets. It is also required for the business to keep growing (not just in size and scale;) large cash holdings and significant equity can sometimes be a sign of poorly allocated capital. Strength and discipline refers to avoiding both (opposite) extremes, and staying on task and on point with your strategic business plan.

Ideally, your financial backstop is a balance of all 3 points above. Too much, or too little, of any one point will be far less effective as a functioning backstop.

To Plan for Prosperity

Knowing your risks and actively managing them is the key step to understanding how much of a backstop you need. Under-emphasizing your risks or over-emphasizing your backstop both have potential to be detrimental to your business’ health.

paperclips

Paperclips

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Many farm offices and kitchen tables are buzzing right now doing crop plans and working out cost of production scenarios. What makes money? What doesn’t? What can we really yield? What are input costs going to be?

For too long, “cost of production” was “inputs.” Seed, chemical, and fertilizer were all that were considered when discussing “cost of production.” Slowly, the recognition of fixed, or operating, or overhead costs came into play. But even then, I still find that much is left to be desired.

Regular readers of this commentary know that I preach “Unit Cost of Production (UnitCOP).” The thinking behind UnitCOP is to evaluate what it cost your business to produce one unit, whether that be a bushel of canola, a tonne of barley, an “eight-weight” steer, a kilogram of butterfat, etc. Obviously, the more units you can produce without increasing overall costs lowers your UnitCOP, as does producing the same number of units but with a lesser total cost.

The mindset of including all costs and expenses when determining cost of production continue to evolve. When in discussions with anyone, client or stranger, about cost of production, I often need to look for clarification about their parameters by asking “Whole farm?” Even this leaves much open to interpretation: whole farm to some means “every acre.” To me, it means every acre, yes, but also every expense.

An example that makes me scratch my head is when I read new articles containing info or quotes from someone in Manitoba Ag. Recently, I read this article about management of agronomic economics, when as with other similarly sourced articles I’ve read in the past the content describes “break even prices and yields” for various crops excluding labor. Why? Will the crop magically seed and harvest itself?!?!

Every cost, every expense must be considered when calculating cost of production. Right down to the paperclips for the office.

To Plan for Prosperity

The business of farming is difficult enough without making it harder to define profitability by ignoring some of your costs. While paperclips may not be critical to “production,” as a farmer/rancher/dairy-person/etc, you are in the business or producing grain/beef/milk/etc. And the costs to run your production business includes things like paperclips.

When evaluating results that might not have met expectations, ask yourself if you remembered the paperclips.