Farm Business Analysis: Important Ratios PDF

## Farm Business Analysis: Important Ratios ### 3. Net Operating Income - Net operating income shows what is available to pay for new farm investments, family living expenses. - It is the bottom line of the business and is the single most important indicator of profitability. - Net operating inco...

## Farm Business Analysis: Important Ratios ### 3. Net Operating Income - Net operating income shows what is available to pay for new farm investments, family living expenses. - It is the bottom line of the business and is the single most important indicator of profitability. - Net operating income = NFI - (income taxes + interest on loans) ### 4. Profit Margin (PM) Ratio: - Or operating profit ratio, a useful measure of farm profitability which quantifies the proportion of farm income kept as operating profit, or the amount of profit generated in each LE of revenue from investment. - A farm business has two ways to increase profits either by increasing the profit per unit produced, or by increasing the volume of production if the farm business is profitable. - Profit margin (%) = Net farm income / Gross farm income x 100 ### Interpretation 1. A low profit margin ratio indicates that the business is unable to control its production costs, low amount of earnings, required to pay fixed costs and low profits that generated from revenues. 2. The profit margin ratio is a good ratio to benchmark against competitors. 3. Profit margin ratios state how much profit the farm makes for every pound of sales. ### 5. Net Cash Income - Net cash income is the difference between cash income and cash expense. - Net cash income = Cash income - Cash expense - Net cash income is the amount of cash available to pay income taxes, cover family living, meet loan principle payments, replace machinery, and equipment, save, or reinvest in the business. ### 6. Milk income less feed costs (MIFC) - It is a useful special measure of cash profitability in dairy enterprises because it is relatively easy to measure and provides a guide to how well the cows are being fed. - MIFC = (milk income) – (feed costs for milking cows) - It does not take into account the costs of feeding the non-productive stock on the farm, namely the dry cows and replacement heifers. - In addition, changes in MIFC are quick to monitor because of the rapidity with which milking cows respond, even to small variations in their feeding management. - When introducing new feeds into the diet or varying their amount, the cows milk responses will reflect these changes within a few days. ### 7. Gross Margin - Gross margin is gross income minus variable costs. - Gross margin = Gross income - Variable costs - Gross margins are used to choose between enterprises in the short run that have similar fixed costs. - It is incorrect to evaluate enterprises that have large differences in fixed cost by using only the gross margin; i.e., comparing a cow-calf enterprise to a stocker cattle. - Gross margin should not be used for long-term planning or investment analysis or estimating costs of production since fixed costs are not considered. ### 8. Milk gross margin (MGM) - Another way to quantify cash profit in dairy farms is to use the milk gross margin (MGM). - This calculates the income from milk sales less the variable costs to produce that milk. ### 9. Milk profits - The simplistic way of looking at the economics of milk production is to use the following equation: Milk profits = (Milk profit margin) X (Milk quantity) - Milk profit margin is the difference between milk returns and all expenses, expressed per kg of milk sold. Quantity is the amount of milk sold, expressed in kg. Together, they determine milk profits. - Without a good margin, farmers have to produce large volumes through milking more cows and/or increasing milk yield per cow. - If they have a good margin but a low volume, farmers will not be able to generate a reasonable income for their family living. - Increasing milk volume can improve milk profits in two ways. Firstly, the profit margin is applied to more volume and secondly, unit costs for feed, other variable and overhead costs are diluted over a larger quantity. - Knowing their margin, hence cost of production is then critical to operating a profitable dairy enterprise. - Another way of looking at margins is that saving money in producing milk (that is, reducing the production cost) is the financial equivalent of increasing milk returns. - Farmers must do more and better planning if they are to achieve greater profits. ### B. Rate of return on farm assets (ROA) - It is often used as an overall index of profitability of the farm business by measuring the rate of return (net income, profit) that the farm business earns on its average asset over specific period. - The higher the return is, the more profitable the farm business. - So, it provides a guide to those responsible for the use of capital (this could be an individual, manager or a government). - Rate of Return on Farm Assets = ROA = Net Income / Average Total Assets - Example: (8,915/759,083) x 100 = 1.17% - Typical ROA for many farms are in the 2% to 5% range. - If you use current market values to determine the worth of your assets, you can use the ROA to compare your earnings to those of other businesses for the same time period. - The ROA also represents the opportunity cost of having your assets invested in the dairy business as opposed to investing in another business or other investment opportunity that might generate a higher or lower return. - Factors affecting rate of return on farm assets: 1. How assets are valued 2. Profitability of the farm business 3. Level of owner withdrawals for unpaid labor and management 4. Amount of unproductive or marginally productive assets 5. Whether assets are owned or leased. ### C. Rate of return on equity (ROE) - It provides a measure of the return on the owner's equity capital that invested in the farm business. - The farm equity is the capital that could be invested elsewhere (if you were not farming), and so this analysis provides an indication about what is the return you are receiving on your investment in farming, as compared to other alternatives enterprises. - i.e. The ROE measures effectiveness of annual inputs such as labor, fertilizers, machines and other resources used to operate dairy enterprise. - A typical ROE for many farms is in the 4% to 8% range. The higher the ratio value is, the more profitable the farm operation. - The return on farm equity (ROE) is calculated as follows: (Net Farm Income) ÷ Average Total Farm Equity X100 - Example: (4,185)/393,875) x 100 = 1.06% ### Interpretation - ROE determine how many dollars of earnings they derive from each dollar of assets they control. - It’s a useful number for comparing competing companies in the same industry. - Calculating ROE shows the farmer how efficiently he is running the annual operations of his farm business. - If it is very low, the farmer should consider alternatives by asking the questions: - Can he increase his ROE by using better farming methods, borrowing extra money to improve production or diversifying farm enterprises? - Should he transfer his capital from this farm and move to a different locality where it is likely to be higher? - Should he sell up and move into another form of investment? - Is his ROE low because there has been a large increase in value of his assets? - Should he use his increased equity to borrow more money to further develop his farm and earn more income? * The document is missing visual elements like diagrams and graphs which are referred to in the text.