Originally published March 23, 2020 on Alberta Farmer Express
Some farmers are way more profitable than others — so do what they do, says farm finance expert
These are difficult days for farmers — but also a time to look at what you can do differently.
“If you’re not a top performer, you’re likely not consistently profitable, you’re going to be susceptible to those market fluctuations, and you’re probably unable to consistently invest in your business,” said Connie Adam, associate partner at MNP in Lacombe.
“You’re not thriving. You’re probably just surviving.”
The average return on investment was slim — 1.7 per cent for crop producers, 2.1 per cent in poultry, 1.8 per cent in dairy, and -4.4 per cent for hog producers.
But returns were more than double for the top 25 per cent of farmers — with cropping at 3.9 per cent, poultry at 4.2 per cent, dairy at 3.8 per cent, and hogs at 1.7 per cent.
“Top performers are profitable, they’re better able to manage market fluctuations, and they’re more likely to be leaders in the industry,” said Adam.
“The average producer is making money — it’s just not as much. If you’re in the middle 50 per cent, you’re holding your own, whereas the top 25 per cent are probably more set up for growth.”
So what sets them apart?
In her presentation and a subsequent interview, Adam cited five key practices: Maintaining solid fundamentals, challenging the way you think, benchmarking, managing expenses, and having effective risk management strategies.
The first thing top farmers look at are financial ratios — such as current (current assets divided by current liabilities), debt service coverage (net operating income divided by debt servicing costs), debt/asset, and equity/asset.
Take for example, the debt service coverage ratio (debt service is interest costs, principal repayments and lease payments).
“If we have a debt service capacity of 1.5:1, we’re looking at a really healthy operation,” said Adam.
“If Farmer A has a 2:1 ratio and Farmer B has a 0.5:1 ratio, which business is going to grow with less risk? Which one can take advantage of land that comes up for rent or land that comes up for sale? And can they get better rates with their bankers?”
But there’s no single magic number. For example, a farmer who hates having debt and tries to pay it off too quickly can have cash flow issues, she said, citing a client who had termed their debt out over seven to 10 years.
“They were trying to repay it really quickly, and though it was saving them interest costs, it was really strapping their cash flow,” said Adam, adding that producer arranged to lengthen the term of their debt.
“The more access to cash they had, the better able they were to manage their ups and downs without relying on the operating line of credit as much.”
Ratios are a way to overcome a natural tendency to rely on your gut or what experts call ‘cognitive bias,’ she said.
“It’s making a decision based on our personal experiences and emotions,” said Adam. “We can make decisions faster that way, but on the negative side, it can also lead to errors because we’re not considering all the information that’s available to us.”
Top performers set emotion aside when determining what worked well and what didn’t. Owning up to decisions that didn’t work out is tough — so you should have advisers and use them, she said.
That’s also why benchmarking can be so effective.
“It helps to identify their strengths, weaknesses, and the opportunities for them to maximize their profits.”
Benchmarking is generally simple and the results are easy to interpret, allowing producers to make decisions with real-time information.
“You can drill down into performance gaps to figure out where slight changes could make a difference,” said Adam.
Often benchmarking will reveal areas where expenses are out of whack.
Another client — this one a livestock producer — found that his gross margin was below the industry benchmark as a result of higher-than-average feed costs. So the producer went to the feed company and worked with their animal nutritionist to adjust the feed rations.
“By doing that, he got his feed costs down close to the industry standard and increased his profitability.”
But the concept of ‘garbage in, garbage out’ applies here.
“If the right things aren’t being recorded consistently, doing any benchmarking and looking at those ratios can be somewhat futile.”
Benchmarking should also help with expense management, another thing that sets top performers apart.
They typically spend about 48 per cent of their revenue on production expenses, 24 per cent on labour, power and machinery, and eight per cent on their land, buildings, and finance costs. That leaves a 20 per cent gross profit.
And the bottom 25 per cent?
It’s closer to 64 per cent on production expenses, 36 per cent on labour, power, and machinery, and a small percentage on land, buildings, and finance, leading to a loss of 13 per cent.
“There’s quite a large spread between being a top performer and a bottom performer,” said Adam.
Despite their higher profits, top performers also cover off their risks through production and income insurance.
However, risk management needs to be regularly evaluated, she said.
“No two farms can have the same risk management strategy, so while coffee shop talk is a great way to spend your time, we can’t make our decisions by it.”
Real-time information is key because so many important decisions require knowing where things are at right now.
Every farmer has access to this information — it’s just a matter of pulling it all together into something you can use, said Adam.
Ideally, farmers would have done this over the winter months before they settled on their production plans for this year.
But now is the time to make a start because the biggest hurdle is accepting that you need to change things.
“We get into the habit of doing things because it’s the way it’s always been done, and with the industry changing so much, we can’t afford to do that anymore,” she said.