We tend to get our understanding of profit measurements confused. At least I do.
Last week I had lunch and a good conversation with my old friend Jay Franklin, a no-till farmer from Vinita, Okla., who has always been an economist at heart and for several years now a banker, too.
I was lamenting the change in business attitudes in corporate America, how 10% was once considered a good return but now most companies want 20-30%.
Jay asked me if I was confusing return on investment with return on equity. (See my links at the bottom of page two for the conflicting definitions.)
I had to answer him that I'm not sure. I was just listening to the figures and assumed they were talking about long-term profits on the amount they have invested, which is ROI in the business world.
When I got home, I determined to do two things:
1. Study the difference in the two measurements to be sure I understand
2. Ask people in the future which they are referring to
So, for your benefit and mine, here's a review of how to measure our profits and why it matters.
I found significant differences in how agriculture looks at money and how publicly traded corporations look at money, so I'll try to bridge the gap as best I understand it. You financial fiends out there feel free to correct me.
Return on Invesment (ROI) is calculated by dividing the benefit of an investment, or its return after subtracting basic costs, by the cost of the investment. The result is commonly expressed as a percentage or sometimes as a ratio.
When we're figuring the return on stocker cattle or feeder cattle, this is normally measuring return on investment, meaning how much return/profit are we going to make on the money we put up. ROI is very important and needs to be high enough so we have a chance to make a good return on our equity (ROE) and or return on assets, which would be the land, the pickup, the corrals, the tractor and the hay baler.
I always tend to get these things backward, perhaps because I think of equity as available money and investment as something I have tied up.
In fact, as Jay Franklin reminded me last week, the return on investment should be pretty high -- ideally 20% or more. Further, the more equity you're putting at risk the more profit you should typically demand -- a better risk-reward ratio.
This was a topic of conversation that afternoon between myself and Wally Olson, a beef producer who I've watched for 20 years as he has amassed a pretty impressive portfolio of livestock.
We agreed that the risk-reward ratio is seriously out of whack right now in the beef industry, with our risk about tripled from just five years ago and our profit margins, if we're lucky and cagey, perhaps double but likely not that much. That excepts last year, perhaps, when it was hard to do anything wrong and not make better-than-average money.
The beef business
Now let's consider the way most folks look at purchasing cows/heifers, which is something going on right now across most of the country. Generally, this is much more an effort in seeking return on equity, or in agricultural economic terms, return on assets. Most people buy the cow for $2,500-4,000 and hope to get enough calves to make a return on their equity/assets, minus her salvage value, and plus or minus depreciated value at cull time. This is the long-term approach to owning cows and the actual money down is more a part of your overall equity and assets than it is return on equity, again excepting the depreciation schedule and her longevity.
However, I think it could be well argued that her costs of production, which you must spend every year, are very much a part of return on investment for those calves you hope to sell each year.
In a more understandable discussion, Dave Pratt, proprietor of Ranching for Profit, wrote three blogs a few months ago on profitability.
He said this: "Cutting overheads, improving gross margin per unit, and increasing turnover, if the gross margin per unit is healthy, are the only three things that anyone in any business can do to increase profit."
I've been harping on low-cost production and improving gross margin per unit for years now. Wally Olson is schooling me in the art of increasing turnover. It's a trick more common among some stocker operators and cow traders, but it's certainly a viable business tactic.
If you turn over a dime to make a penny profit five times in a year, that beats making 3% on that dime for the whole year, see?
I'll write more about some of the things Wally has been teaching me and others in my next blog.