One of my themes for the 2020 speaking circuit will be taking ownership of your numbers. Increased uncertainty in the agriculture business climate surrounding trade, tariffs, and international markets layered with extremes in weather require one to monitor key operational and strategic numbers. With larger businesses exhibiting more zeros and commas on the balance sheet, monitoring financials at least once per year is no longer an option, but a requirement. Let’s examine a few of my favorite ratios and metrics as many of you conduct harvest and are ready to close down year. The following will hopefully lead you to think more critically about your business.
Working Capital
The top half of the balance sheet is key to the short and long-term operational success of your business. Working capital is calculated by subtracting current liabilities from current assets. While many lenders will use the current ratio to measure the adequacy of liquidity, working capital divided into total expenses will give you more perspective on the appropriate amount of working capital to maintain for your unique operation. Working capital must be monitored throughout the year and year-over-year using trend analysis.
Working capital to expenses above 25 percent indicates a strong working capital position. When this ratio is under 10 percent, this is a sign of caution. Working capital is analogous to having a queen on a chessboard. The queen gives you moves and alternatives. Giving up the queen or your working capital restricts both short and long-term alternatives. Cash may be king, but working capital is the queen of the financial statements.
Operational Efficiency
An old-time favorite ratio of mine is calculated using total operating expenses, excluding interest and depreciation, divided by total revenue. Again, one must examine this metric year-over-year to determine the trend. Accrual adjustments of inventories, receivables, payables, accrued expenses, and prepaid expenses often provide a more accurate picture of the operating efficiency ratio. While in recent years many producers have seen margin compression, the top third of profitable producers generate a dollar’s worth of revenue with generally under $0.75 of expenses. In the “go-go” years of the super cycle from 2007 to 2012, the operating expense ratio was south of 65 percent for the top-third of profitable producers. The bottom third of producers have an operating expense ratio above 90 percent for many sole proprietorships. Often corporate entities and individuals who rent and lease many of their assets will exhibit less operational efficiency with smaller margins because they report greater rental expenses and less interest expense. Keep in mind the unique characteristics between each operation that can explain the differences seen in the financial statements.
Full-time Farm
Many aspiring young and beginning farmers will work off-farm jobs to grow the business. Others will seek entry into farming through their families. An old rule of thumb is $40,000 to $70,000 of net farm income is needed to be a viable, sustainable operating business, whether starting a business or entering an existing family business. Violation of this number often finds business conflict and profits being squeezed by too many owners and managers for the size and the scope of the business.
Family Living Costs
Family living costs is the most subjective number in farm and small business operations. The spread between high family living expenses to low family living expenses often can be $40,000 to $60,000 after-tax. Family living budgets are just as critical as a farm budget. Another factor in family living costs is that up to 30 percent of expenses are co-mingled with the farm expenses. Ownership of these numbers with crucial conversations can impact growth and survival strategies. Often a refinance or restructure of an operating loan to term debt for 10 to 20 years can be linked to family living costs because the size and scope of the business is not large enough to support the family.
The 50 Percent Rule
Many farm businesses, as a result of farm demographics, are transitioning ownership from one generation to the next. While the focus is often on the younger generation and their living costs, the senior generation also must be considered. Can the seniors generate at least 50 percent of their retirement livings needs with social security and investments outside the sale and lease of the farm to other family members? Although the total retirement need varies for each family, the senior generation in effect can represent up to a $1 million annuity that will be paid for by the sale of assets, lease of assets, investments outside the business, or social security.
Junior Perspectives
Many reading this column have children and grandchildren. This is where the 50/25/25 rule comes into play. Many agricultural producers pay their children to work in the business during their youth. If this is the case, 50 percent of the earnings can be spent at their discretion. Twenty-five percent of the child’s income should be saved for future education and 25 percent towards long-term investments. Remember, your philosophy regarding finance is created between four and 15 years of age. This is where great guidance to get them to take ownership of the numbers at a youthful age can be very important.
Remember, taking ownership of your numbers and growth is a focus for 2020. This allows you to manage what you can control and then manage around the uncontrollable variables. Have a safe harvest!
