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Profit margin compression, part 2: Operating expenses to revenue ratio

The last column centered on how margin compression is occurring across the spectrum regardless of whether it is the top or the bottom 20% of agriculture producers. This was based on FINBIN data utilizing the rate of return on asset (ROA) metric recommended by the Farm Financial Standards Council.

Let’s dig a little deeper and examine one of my favorite ratios that measures financial efficiency.  The operating expense to revenue ratio (excluding interest paid and depreciation) is very useful because it determines the amount of expenses it requires to generate one dollar’s worth of business revenue.

Historically since 1995, the top 10% and top 20% of producers pay approximately 70¢ to generate $1 worth of income. This leaves 30¢ for debt service, family living withdrawals, capital replacements and any other investment items. For the first time in almost a decade, this ratio has crept above 70¢, averaging 73¢ on $1 for both the top 10% and top 20% of agricultural producers in the FINBIN database.

The average producer on these databases typically spends 73-75¢ to generate $1 of income, leaving only roughly 25¢ for the aforementioned financial obligations. It is disturbing that this ratio jumped above 80¢ in 2013 for the first time since 1995, illustrating severe margin compression, particularly amongst the average producers.

Now let’s discuss the low 20% of producers on FINBIN. While historically the operating expense to revenue ratio will average 85¢ on $1 for this segment, which is a less than stellar margin, 2013 results illustrate an old saying by an Apollo 13 astronaut: “Houston, we we’ve got a problem.” Why? This ratio came in at nearly 100%, or approximately breakeven, without considering interest paid and depreciation. Many producers will contend that this ratio is not too disturbing and next year will be better. What if next year is not better?

Please keep this data in perspective, realizing that producers whose records are on the FINBIN database generally are in the top two-thirds of managers in the industry because they keep good records and work with outside farm management instructors. Do you ever wonder about the other farmers and ranchers and where they stand?

Next time I will cover more thoughts about margin compression.

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