Are your assets working as hard as you are?
As dairy farmers you and your employees work very hard. Cattle need to be fed, milked and cared for every day. Crops need to be planted, cared for and harvested in a timely manner. Business success takes tremendous dedication and skill.
Have you ever contemplated how hard your assets are working for you? A common way businesses measure how hard assets are working is by calculating asset turnover ratio. Asset turnover is easy to calculate and is simply annual total revenue divided by the total assets invested in the business.
Asset turnover ratio is an efficiency ratio that measures your ability to generate sales from the total assets invested in the business. In other words, this ratio shows how efficiently you are using assets to generate sales. For instance, a ratio of 0.5 means that each dollar of assets, annually generates 50 cents of sales. Figure 1 shows the average asset turnover ratio over the last 10 years. The average over these ten years is 0.45.
Research at the University of Minnesota in 2001 showed that the best predictors of a farm’s net worth growth was family living expenses and assets turnover ratio. High family living expenses had a negative effect while high asset turnover ratio had a positive effect on net worth growth.
Of course this isn't the only factor that drives profits on farms. The other side of the profit equation is operational efficiency. Businesses earn profits by mixing their labor and management with inputs and capital assets to produce goods for sale.
Let's look at a simple example. If a farm has a total of $1,000,000 of assets and gross income of $400,000, the asset turnover is 0.4 or 40% (400,000/1,000,000). If the cost required to generate this income is $300,000, the operating profit margin is 25% (300,000/400,000). The overall profitability (return on assets) in this example is 10% (25% x 40%).
This example shows that drivers of profitability are how well the business uses assets and input cost to generate gross revenue. Operating profit margin is a measure of operational efficiency or how many cents are needed to generate a dollar of income. Asset turnover ratio is a measure of efficient asset use or how well the farm is able to generate income with the business's assets.
To optimize asset turnover ratio, think about new investments carefully. Here are some ideas to think about when considering new investments.
- Does the new investment fit the long term goal of the farm?
- Will new investments improve future earning potential? It is better to anticipate good years and invest in assets anticipated to have a high return, such as better transition cow facilities, or improved cow comfort.
- Will the new investment decrease expenses such as labor?
- Does the investment improve operational efficiency?
- How fast will the asset depreciate?
- Will the new investment result in an improved family lifestyle? There is nothing wrong with making investments for lifestyle reasons as long as it does not limit the long term competitiveness of the business.
Develop a long term capital replacement plan. In general, the best income producing assets on dairy farms are cows. Generally, over-investment in new machinery and equipment will contribute little to the income earning potential of a farm. It is tempting to make quick investment decisions around tax planning time with the goal of minimizing taxes. If there is a long term capital improvement and replacement plan, you can anticipate good years and follow your plan.
Examine your business for unused or underutilized assets. Will these assets be better used in the future or can they be sold? Many dairy producers have under-utilized equipment because of limited hours for fieldwork between chores. Could equipment be shared with or leased to another farmer? Can some field work be custom hired? Often forage quality is better if forage is custom harvested. Are facilities being fully utilized?
In general, farms that have a limited land base and only own cows will have higher asset turnover ratios but lower operating profit margins. Dairy farms with large land bases tend to have lower asset turnover ratios but higher operating profit margins. However, farms that control less land and purchase feed are at a higher risk of widely fluctuating feed prices.
Understanding the importance of making your assets work hard for you will improve your long term profitability and ability to grow your business. Benchmarking your farm with other similar farms will help you determine your strengths and opportunities. If your profitability, asset turnover and operating profit margin are high, keep up the good work! If some of the areas could use improvement, work with your advisors and others to develop a strategy to improve farm profitability.
FINBIN - Data from Upper Midwest Farm Management Associations