Last month I wrote that at our summer conference, an area of great interest was the concept of establishing return on asset and return on equity goals in your farming operation.
Return on assets is your net-worth gain — after living, taxes and depreciation — divided by your total assets. Return on equity is your net-worth gain divided by your beginning-of-the-year net worth.
At our conference I shared data of five clients (names removed) where I had completed their yearly plan just a few weeks prior. They had return on assets of 6-10% last year and return on equity results of 10-24%.
How do these returns compare to other industries? I reviewed my April 15, 2002, issue of Fortune magazine. That issue featured the Fortune 500 companies — the largest companies in America, most having international operations. Those companies sorted into 48 industries, with only six of those 48 having return on assets greater than 6%. The average return on assets of all 500 companies was 2.5% in 2001.
This points out that there is money in production agriculture and it can be as good as other industries.
Back to the data from our customer base. The interesting point was there is no correlation between profitability and the size of operation. One was small, one large and three medium sized. We have found no profitability to size correlation through our customer base, which covers 17 states. However, there are four key areas we discussed that do affect profitability results and a fifth that is less important, but still can add to your bottom line.
The first area that separates those that make good returns from the rest is marketing. Good marketing decisions can add up to $70/acre of extra income. These are actual results we've observed compared to those who marketed their crops at loan rate. Unfortunately, there are farmers that do not even get loan rate for their crops.
The second area of great leverage is managing machinery cost/acre. I've written about that before in Riskwise, and it's important because the fixed costs of interest, depreciation and repairs can amount to 25% of balance sheet value each year.
We often see $50/acre variance among operations in this area. Spreading machinery costs over more acres is the easiest way to leverage your profitability. Leasing instead of owning can be another alternative to improving return on assets and return on equity. The right decision is based on each individual situation and it's best to run the numbers on both leasing vs. buying.
The third profit point is inventory management. Today, many companies have implemented “just in time” inventory to reduce interest costs. Money saved on inventory goes right to the bottom line as profit. The mistake many producers make is holding inventory too long, waiting for a price rise.
It makes good sense in many situations to store grain until the basis improves and allows you to take advantage of potential carry in the market. But storing grain for longer periods hurts your overall returns.
Iowa State University data indicates six months of interest cost, extra drying, shrink, handling and quality deterioration amount to 18¢/bu. On 135 bu/acre, that translates to $24/acre, and that doesn't include fixed storage costs.
The fourth and fifth areas of enhanced profitability will be covered in next month's Riskwise column.
Moe Russell is president of Russell Consulting Group, Panora, IA. Russell previously spent 26 years with Farm Credit Services as a division president. For more risk management tips, check his Web site (www.russellconsulting.net) or call toll-free 877-333-6135.