To build a resilient farming business – know your financial targets
Author: Brian Watts (Watts Price Accountant) | Date: 20 Jun 2019
Take home messages
- If you want to improve your farm performance, know your starting point, decide on what you want to improve and have an end point or goal in mind in terms of key performance indicators (KPIs). They are the guide posts.
- Become very familiar with the key drivers of your farming enterprises (cropping, livestock); understand the key Wimmera farm financial benchmarks or KPIs and calculate those KPIs yourself to better understand your own farm business.
- The Pareto Principle should not be overlooked. It is forever present.
- Use the Stop, Start, Continue process to introduce change into your farming practices.
- Marginal analysis is a fundamental economic principle that underlies successful businesses.
- Many of the possible gains involve minimising the losses currently happening.
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Business resilience
Business resilience essentially refers to the ability of a business to continue operating despite the many risks, disasters, downturns, poor seasons that it may encounter. To build farm business resilience implies managing risk, reducing losses, but most importantly managing good years by preserving profit and wealth to endure the poorer years that will happen.
Background
Current day use of key performance indicators (KPIs) or benchmarks:
- A financial KPI tends to be expressed as a percentage, or relative number between two results. Productivity is an expression of output per unit of input. Profit is often expressed as a percentage of sales, or the number of cents in the dollar sale. Crop yields, as an example, are often expressed as tonnes produced per area farmed.
- There would not be one corporation listed on the stock exchange that does not use KPIs to assess performance. Myer, David Jones, JB Hi Fi, for example would monitor sales, profit margins, average consumer spend, foot traffic and many more KPIs on a daily, weekly, seasonal and yearly basis. Trends are monitored and changes are made to product range and marketing strategies.
- The Horsham Plaza measures foot traffic on a daily basis. This KPI alone will indicate if more or different publicity is required to generate consumer interest and sales.
- Qantas and V/Line monitor daily KPIs on aspects that are important to travellers. These include percentage of flights and trains that depart and arrive on time and the percent of cancellations. Qantas monitors the time taken for luggage to get from touch down to the carousel. All vital measures for traveller satisfaction.
- All banks have many KPIs including customer satisfaction, staff satisfaction, customer movement to and from, average loan balances, non -performing loan percentages plus many more.
- With farming the timeline is different to other businesses, and therefore, KPIs are better monitored on a yearly or better still a 3 to 5 year moving average of the key financial KPIs or benchmarks.
Brief outline of financial reporting conducted by Watts Price Accountants
- Seventeen (17) KPIs are calculated using five year rolling averages.
- KPIs on profitability, productivity and financial position are calculated.
- KPIs for five sub regions within the Wimmera are monitored.
- Medians, the sub-region average and the average for the Top 20% most profitable farms for each of the 17 KPIs are calculated for each year surveyed plus the five-year rolling average for those 17 KPIs.
- The largest farms in our 2018 Survey had over $30,000,000 in assets under management and the smallest farms had $2,000,000 of assets under management.
The basic formulae
Our Wimmera farm financial KPIs provide local benchmarks that will assist with achieving long term sustained profitability. By knowing where your farm currently is in relation to the current median KPI for each of the key financial benchmarks you will be provided with guidance on what aspects to focus on. Consider what needs to change to move into the 1st and 2nd quartiles to assist long term business resilience.
Table 1. Basic formulae for measures that are utilised in calculating key farm financial KPIs.
| Gross Farm Income (GFI) |
| less Farm Operating Costs (FOC) |
| equals Farm Operating Surplus (FOS) |
| less Owner's Notional Market Wage |
| less Depreciation (loss of market value) |
| equals Farm Operating Return (FOR) |
| less Finance Costs (FIN) |
| equals Farm Net Profit (FNP) |
What does the survey tell us about the last five years with regards to profit?
Table 2 includes results from the Watts Price Accountants farm survey for the five-year period (2014 to 2018).
Table 2. Comparative profit over the five-year period (2014 to 2018).
For the period 2014 - 2018 | 2014 | 2015 | 2016 | 2017 | 2018 |
|---|---|---|---|---|---|
Percentage of farms that had a positive Farm Operating Surplus (FOS) | 97.7% | 82.9% | 67.5% | 95.2% | 100.0% |
Percentage of farms that had a positive Farm Operating Return (FOR) | 86.4% | 48.8% | 32.5% | 81.0% | 97.3% |
Percentage of farms that had a positive Net profit (NP) | 77.3% | 36.6% | 20.0% | 78.6% | 89.2% |
The key financial benchmarks (KPIs)
KPIs can be used to benchmark various financial aspects of your farming business. Some KPIs are better suited to use for (internal) benchmarking than others; that is to benchmark your farm over time. An example of one KPI that is better used for internal benchmarking and for a local area is Farm Operating Return per hectare. Other KPIs can be used for both internal and against industry benchmarks (external).
Of the 17 KPIs reported by Watts Price Accountants the nine that farm business owners should focus on and can be used to benchmark various financial aspects within their own business include:
- Return on Assets under Management
- Return on Equity
- Farm Operating Costs
- Plant Productivity
- Land Productivity
- Labour Productivity
- Asset Turnover Ratio
- Equity Ratio
- Interest Cover
Wimmera Farm Key Financial Benchmarks
The ‘Good’ the ‘Bad’ and the ‘Ugly’
Table 3 demonstrates a range of KPI results for farms operating in the Wimmera region.
Table 3. Median results for some key performance indicators for the median, Bottom 20% and Top20% farms surveyed within the Wimmera region
Median Results (2014 - 2018) | Ugly Good Outstanding | ||
|---|---|---|---|
Bottom 20% | Median | Top 20% | |
Equity Ratio | 90.5% | 93.3% | 89.6% |
Return On Assets | -3.2% | 1.9% | 6.1% |
Return On Equity | -4.0% | 2.3% | 8.6% |
Farm Operating Costs / Gross Farm income | 110.1% | 58.2% | 42.8% |
Plant productivity | 353.3% | 123.7% | 83.4% |
Land Productivity | 1.1% | 5.9% | 13.6% |
Labour Productivity | $189,404.77 | $348,635.85 | $589,923.14 |
Assets Turnover Rate | 7.1% | 10.7% | 16.9% |
Interest Cover | 0.9 | 4.0 | 5.2 |
The median results for the KPIs listed in Table 2 can be regarded as the contemporary benchmark, as 50% of respondents performed better than the median and 50% of respondents performed below the median results.
A closer look at the median farm over time
Table 4 illustrates the median farm’s performance for three years; 1999, 2009 and 2018.
Table 4. KPIs for the median farm recorded during 1999, 2009 and 2018.
1999 | 2009 | 2018 | |
Gross Farm Income (GFI) | $130,546.45 | $247,514.41 | $634,482.76 |
Land Farmed (Ha) | 733.5 | 917.5 | 1000 |
Total Farm Assets Managed | $1,124,050.05 | $2,778,670.19 | $6,530,884.00 |
Farm Operating Costs (FOC) / GFI | 66.5% | 65.7% | 44.7% |
Equity Ratio | 89.4% | 82.4% | 95.9% |
Return on Assets | -2.3% | -1.6% | 3.7% |
Return on Equity | -2.6% | -1.6% | 4.5% |
A message of caution: Be aware that the Profitability KPI’s have been deflated by the more recent rapid increase in farmland valuations. Both the Return on Assets under Management KPI and the Land Productivity KPI will be halved if farmland values have doubled over the period of ownership. Why then use current farmland market values? The concept of opportunity cost provides the answer. Based on current Return on Investment (ROI) if you are earning unsatisfactory returns and returns elsewhere are far superior, you could do better despite making excellent returns on a lower historical cost investment!
Using farm financial benchmarks to encourage change
Our suggestion for improvement in farm profitability
Select any KPI and use the following process with all participants in a farming operation to encourage change. This includes the owners, family, managers and any employees. Get all the team on board. I am sure you are doing this informally now. Try formalising this process to achieve better results.
Using the STOP, START and CONTINUE process, brainstorm as a group under the following three headings:
- What worked or is currently working well?
- What did not work or is not currently working well?
- What could be introduced or changed?
Use this process for any major aspect of your farm business such as:
- Cropping
- Pest control
- Cost control
- Harvest
- Grain storage
- Marketing
- Succession
- Use of technology
- General planning
- Off-farm investing
- Work-life balance of all family members
How to structure your meeting
- A topic is selected and briefly outlined by the chair of this meeting. Use an external facilitator if you feel uncomfortable but best of all is give it a go.
- Select an easy topic to start with then use the STOP, START, CONTINUE process to analyse it in line with the rules of brainstorming:
- A note-taker is nominated
- There is no such thing as a silly answer
- No group discussion takes place at this stage
- Only permit five minutes to each topic
- The optimum number involved is four or five people
- Start with positives, so ‘What are we doing well?’ ‘What are we not doing so well?’ then onto ‘What should we consider doing?’
- The final step once the thoughts are compiled is a discussion of for and against the thoughts raised, any necessary research completed and then a list of ACTIONS on the topic in question is drawn up. Essentially, time lines are set to avoid procrastination.
Be fully aware what financial KPIs are vital from a bank’s viewpoint
Multiple factors are examined when assessing a loan application. Banks use a base rate for lending then add on a margin for risk. The stronger the farm business, the lower the risk rating and the lower the cost of borrowing. Two of the most significant KPIs examined are:
- Equity Ratio: Is a measure of the solvency of a farming business. It provides an indication of the ability to withstand losses and to meet financial commitments in the long run. The equity ratio is a solvency ratio that measures the amount of assets that are financed by owners' investments relative to the value of total assets. Another way to look at this is: If all the assets were sold and the liabilities paid out, the owners end up with the remainder. This amount is divided by the total assets to arrive at the Equity Ratio.
- Interest Cover: Is a measure of the farm’s profits relative to loan interest costs on its debt. The higher the interest cover, the lower the risk rating and vice versa. An interest cover ratio of two would convey that the farm profit before interest is double that of the interest expense for that year.
Most importantly banks will assess the Future Repayment Capacity of each application. It is about the ability of a borrower to generate income on a year-in-year-out basis to meet interest and principal repayments. Management ability will be assessed; subjective factors may come into this such as financial literacy, past profit performance and loan repayment history, location of the farm and rainfall reliability plus many more.
The stronger the above two KPIs coupled with the assessment of future repayment capacity, the lower the risk factor and the lower the risk premium paid over and above the base interest rate.
In summary; strategies to build profit and ultimately resilience
- Use the STOP, START, CONTINUE process to brainstorm amongst yourselves to encourage change.
- ‘Look for the twist’ when it comes to attending conferences, or just listening to others in your network groups.
- Don’t lose sight of the Pareto Principle; the 80/20 rule when it comes to economic decision making. As the Pareto Principle suggests, 80% of total output comes form 20% of total inputs.
- Do not lose sight of time management principles of important and urgent tasks and prioritise with that in mind.
- As a family group try to discuss personal goals in an open-minded way as not all family members will have the same life goals.
- In those high profit years, look to retain reserves, minimise taxation, plan before 30 June, and utilise the generous tax breaks currently on offer to faming businesses.
- Use finance in tax effective ways such as using one-year leases to acquire essential plant in high profit years; being far more tax effective than many other alternatives.
- Do not ignore marginal tax rate analysis and rely only on 5-year averaging when it comes to tax effective, resource decision making. Look at the marginal cost and the marginal revenue or benefits. Speak to your advisers who relate to these two fundamentals of financial decision making.
- Farm management deposits (FMDs) can be used as your own source of credit, which has the impact of lowering the cost of finance yet retaining wealth in the farm rather than losing it in taxation.
- Understand the major farm financial KPIs rather than just rote learn them and apply them as a ’road map’ for major decisions such as buying and financing plant, employing labour, leasing or share farming more land and or buying or selling farmland.
- Accept and welcome well considered change. As North Melbourne hero Wayne Carey recently said after a lack lustre start to the 2019 AFL season, ‘No North player will be safe at the trade table’. The next two games North won, against expectations. Perhaps the players felt they needed to change?
Useful resources
5 ways to Measure your Financial resilience
Interest Ratio Coverage Definition
Contact details
Brian Watts or Richard Kemp
Watts Price Accountants
44 Wilson Street Horsham
53823001
brianw@wattsprice.com.au
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