In many of my speeches I emphasize that better is better before bigger is better; that is, get efficient before you embark on growth. What is a good financial measure of efficiency for farm businesses? One of my favorites is the operating expense to revenue ratio. It is calculated by totaling up your farm expenses, then deducting interest and depreciation expense for a subtotal. Next, divide this number by total farm revenue. In layperson’s terms, this ratio shows how much expense it takes to generate a dollar of income.
Let’s examine FINBIN Farm Financial Database trends from Minnesota as a benchmark comparison to determine how economic cycles and financial trends impact financial efficiency. As a side note, farm corporations that take an owner or management withdrawal and producers who rent or lease much of their farmland will have a ratio 10% to 15% higher than sole proprietorships. The operating expense to revenue ratio averaged 65% at the peak of the commodity super cycle from 2010 to 1012. Over an 18-year period going back to 1996, only 2007 averaged better than this three-year period, at 67.2%.
Now for a dose of reality, this ratio jumped to over 80% in 2013 for only the second time in 18 years, with the other instance in 2009. After depreciation and interest were added back in, the result was 8.8% net farm income margin in 2013, similar to the 8.6% margin in 2009. Will 2014 bring the positive margins that followed 2009? As this year is playing out, it does not appear to be the case unless a producer is solely in the livestock industry. Thus, back-to-back lower margin years should result in readjustment of rental cost and some fine-tuning on the expense side of the income statement, along with an effective marketing and risk management strategy. It will be interesting to monitor this financial metric over the next couple years as more data is received.
- 72% is the 18-year average operating expense to revenue ratio, with a range over the period from 62.4% to 81.2%. By the way, the highest recorded during that time span was in 2013.
- 5.7% is the 18-year average for interest expense to revenue ratio, with a range of 3.1% to 8.2%. In 2013, this ratio was 3.8%. You can see how low interest rates impact the bottom line. If interest rates increase in 2015, the result will be a squeezed margin.