Road Warrior

Profit margin compression, part 1

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One of the most enjoyable parts of my life work has been to observe how the Farm Financial Standards Task Force’s work, of which I was facilitator 25 years ago, is now paying off. Today many commercial and state farm record systems utilize the Farm Financial Standards Council’s (FFSC) ratios in their benchmark databases. One such database is FINBIN, which aligns very closely with farm management instructors who, in turn, do an excellent job working with their customers to improve business acumen.

This year’s data summaries are showing some interesting but disturbing trends. If one examines profitability index since 1995, regardless whether it was a crop or livestock enterprise, each year the top 10% and 20% of operations earned a 10% or greater return on assets (ROA). However, the exception is 2013 when returns garnered were 7.8% and 7.4%, respectively.

Average producers were clicking along at double-digit returns since 2005. Now they exhibit a marginal return of 2.6% ROA. Startling was the low 20% of farms, which earned a -6.2% ROA. Yes, one year does not make a trend; however, this bears watching. Why? In over 30 years analyzing and examining farm record data, I have noticed that profitability decline will usually precede cash flow and repayment ability issues by about two to three years.

Could it happen this time? Granted, top-level managers regardless of farm size know the importance of working capital and particularly cash. Others who have not been as disciplined in this area will have to fall back on equity. However, if credit standards and regulatory pressure increases, this option may not be a viable alternative, resulting in operational issues or problems keeping the doors open, lights on, and operating the farm business.

Concerning profits measured by ROA, a return above the interest rate and inflation rate usually means real gain in net worth. However, the lower 80% of this database may be stressed to garner this type of return that will exceed both inflation and interest rates.

Next time, I will continue with more on margin compression!

P.S. One of the best management practices used by producers is benchmarking. That is, benchmarking to your own business trends, analysis and trends of peer operations. On the next appointment with your lender, consultant or farm management instructor, conduct this analysis. You may be surprised both on the positive and negative side. However, with negative results, you can jump on it and develop proactive corrective action.

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What's Road Warrior?

Dave Kohl is an ag economist specializing in business management and ag finance. He can be reached at sullylab@vt.edu.

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