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Extension > Agriculture > Agricultural Business Management > Farm financial management > Benchmark your farm to improve your profitability and financial position

Benchmark your farm to improve your profitability and financial position

Don Nitchie, Extension Educator, Agricultural Business Management

Introduction

Benchmarking is the practice of measuring the financial health and performance of your farming business compared to the performance of your business in the past and to similar or peer farms. Without some standard to benchmark to, or compare, you have little idea if a measurement is good, bad or makes any difference at all. There are many production benchmarks commonly used such as yield per acre or pounds of gain per pound of feed fed. Financial benchmarks focus on how effective annual expenditures on inputs and long term investments in farming assets are. Whole farm financial benchmarks indicate the profitability, financial efficiency and risk-bearing ability of the entire operation. Individual enterprise benchmarks compare how effective expenditures on specific inputs are in producing income, for example seed and chemical for crops or feed for livestock.

Types of benchmarks and data required

There are two types of data or benchmarks to compare to. Each type first requires sound financial records or data from your business. Without collecting and organizing data on your income, expenditures, inventories of assets and liabilities into a readily retrievable form, you cannot easily study your business or make benchmark measurements. The first type, internal to your business is to benchmark your own measurements to your historical data. This establishes your own internal trends. A current number may not look so good but, if it has been improving the last few years, that is positive. The second type is to compare your business externally to peer farms of your type and in your area. This tells you how you are doing in relation to the competition in your industry. Most importantly, external comparisons allow you to learn from others. External, peer group comparisons allow you to see what benchmarks of less profitable and more profitable farms tend to be, in a confidential manner.

Comparison to peer farms

To truly benefit from financial benchmarking your operation internally and externally to peer farms, membership in an organization committed to this concept as a best practice can yield the most benefits. You, your lender or accountant can certainly do the math to calculate a financial ratio or other benchmark for you. But, without being affiliated with an organization committed to the process with people and resources dedicated to it—you sometimes do not know if you are comparing "apples to apples or oranges to apples". To be comparable, data has to be prepared in a consistent manner across several farms with the same methods. Examples of methods that need to be consistent are; inventory valuation, asset valuation, net income calculations and depreciation just to name a few. If differences in key benchmarks are identified by comparison, you want the differences to be real and not due to variability in methods or process. Towards this goal, in such an organization, analyses of records are completed at the same point in time, typically the end or beginning of each year. The data is summarized across all participating farms and reported to all farms. Typically, it is first reported an average farm and then differences from the average farm are reported by enterprise type, size, and profitability levels as well as by stage of career of proprietor and many other categories if the data is sufficient. As each individual's identity in the data-base is protected, there is no incentive to submit anything other than factual data. Members also have an incentive to keep a significant number of farms in the group to maintain a strong level of comparable data.

Peer farm groups; a Minnesota example

Farm Management Associations, traditionally affiliated with University Extension in many states, or Farm Management programs and classes, affiliated with Minnesota State Colleges and Universities here in Minnesota or Community Colleges in some other states, also offer the opportunity to be a part of a peer benchmarking group. They offer training, analysis of your farm records, reports comparing your benchmarks to your internal history and that of peer farms as well as on-farm consultations. Participation also requires payment of fees to cover the costs of the program.

The Southwest Minnesota Farm Business Management Association (SWMFBMA) is part of University of Minnesota Extension. The annual report for SWMFBMA can be located at the Center for Farm Financial Management (CFFM) at the University of Minnesota. This publication includes the latest financial and enterprise benchmarking data from Southwest Minnesota. It also contains discussions of the data contrasted with past trends and economic conditions, as well as a reference section defining and explaining the various financial ratios used as benchmarks. Additionally, benchmarking data can be explored and compared beyond the SWMFBMA throughout Minnesota and with other states by using FINBIN, also operated and maintained by CFFM at the University of Minnesota.

Key steps in the benchmarking process

  1. Become a member of a peer group such as a Farm Management Association that provides training, financial analysis (calculating your benchmarks), individualized comparison reports and consultations.
  2. Determine strengths and areas for improvement–Some examples; beginning at the whole farm level you should determine a few key benchmarks that maybe a concern or are trending in an undesirable direction. You should be concerned about 3-5 year trends not, just a one year change that might me due to weather.

    First a financial soundness measure, if for instance your liquidity as measured by your current ratio, (current assets/current liabilities), has declined over the past few years to 1.4. This means that at the time it was measured there was $1.40 of assets that could be converted to cash in the next year to pay for every $1.00 of current obligations, (accounts payable, annual principle and interest due on loans).

    Secondly, a profitability measure, if for instance your rate of return on assets (ROA) has declined to 5% where every $1.00 of farming assets you own has produced $.05 in profit.

  3. What are your competitors or peer farms achieving? Compare externally to Association member farms through "Rank-em" reports and the Association annual report, or beyond through FINBIN. If all farms of a similar type as yours have declined in a similar fashion, your decline is probably also due to a general decline in prices, a rise in costs or maybe weather that all farms in the region have experienced. If not, or if your decline is greater in percentage terms, further investigation is required.
  4. What caused the Benchmark to decline? Each of the examples in #2 above is a ratio with a numerator and a denominator. So, each is a measure of a relationship of one financial number to another in your business. Both numbers are dynamic and change over time—so the ratio is measuring the balance between the two over time.

    In the case of the current ratio of 1.4., ask the question, has it been primarily that the value of current assets has declined? Or, have current liabilities (operating loans and loan payments) increased significantly? Or has it been some of both.

    In the case of the profitability measure, a decline in ROA to 5%, has profitability primarily declined while the amount of farm assets are unchanged? Or, has there been substantially more investment in farming assets while net returns (profits) are mostly unchanged? Or, has it been some of both?

  5. Further Investigation is required before making positive changes;

    With a Current Ratio of 1.4, if it is determined that current assets are the problem, is it a shortage of cash on hand, a low quantity of inventory of grain or livestock ready to sell—or low prices on existing inventory-compared to peer farms? If the low ratio appears to have been caused by a substantial increase in current liabilities—is the operating loan balance too large or have intermediate assets been purchased with short-term money? Are there excessive fixed annual loan payments due on machinery, equipment or buildings or land?

    For the ROA of 5%, if it is a net return or profitability problem, then you should review benchmarks in your major enterprises. You should begin with major income factors such as yields, pounds of livestock and selling prices. Could it be a bigger problem such as productivity of certain soils or sources of feeder livestock? If it is not an income problem then it has to be a cost problem. Your costs have to be higher than your peers and you should investigate if it is specific direct costs, overhead costs—or a combination of many of these. If so, your input choices, processes and production practices need to be reviewed in detail. Or the profit problem could be both declining income relative to increasing costs. If your enterprise seems to compare reasonability to peer farms, then the cause of your lower ROA has to be that a greater amount of investment in farm assets has been made to get the same returns than your peers. So it may be that you are over-invested or not as "lean" in machinery, equipment or building investments as you could be to remain competitive.

Conclusion

Benchmarking is a process that makes it possible to research your farming business to find opportunities to improve your financial position, efficiency and profitability. Having comparable, quality data is key to making decisions and as a result, begin to take specific actions that are crucial to long-term success. Benchmarking is promoted widely as a "best management practice" by non-agricultural businesses but, is probably even more important to agricultural producers where there is significant difference among producers. Effective use of benchmarking is probably one of the most important tools and skills.

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Contact Don Nitchie at Ph. 507-752-5081 or dnitchie@umn.edu.

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