NEWS for North Dakotans
Agriculture Communication, North Dakota State University
7 Morrill Hall, Fargo, ND 58105-5665

November 25, 1998

[EDITORS: This is the third article in the series "Assessing Your Business for Today's Markets and Beyond."]

The Market Advisor: Financially Speaking, Where Am I?

Harlan Hughes, Extension Livestock Economist
NDSU Extension Service

Today's tough markets call for tough management actions. The first management action that any farmer or rancher should take in coping with today's down market and beyond is to answer the question, "Financially, where am I?" In today's tough times, assessing the financial performance of your business is a high-payoff management action.

By asking the "Where Am I?" question for my example farm, we determined that this farm's business strengths are low cash farm expenses high net cash farm income low 65-cent cost of producing each dollar of gross income high net operating profit and high net farm income. At the same time, this farm's business weaknesses are low gross cash farm income and very high depreciation and capital adjustments.

Now that this farm manager knows his farm's business strengths and weaknesses, business plans for 1999 and beyond can focus on capitalizing on those strengths and reducing the weaknesses.

Five critical control points for answering the "Where Am I?" question will be presented in this and my next several Market Advisors. I strongly recommend that readers use these critical control points to answer the "Where Am I?" question on their farm or ranch businesses.

Critical Control Point Number 1: Calculate Your Net Farm Income.

A farm or ranch family contributes three resources to their farm or ranch business—unpaid family and operator labor, management and equity capital. You know what your fertilizer dealer was paid, you know what your banker was paid, etc., but do you know what your family was paid? The "earned return" to your family's three contributed resources is net farm income.

Net farm income is a measure of profitability that takes both cash and non-cash income into account. Net farm income is determined by first calculating gross cash farm income, subtracting cash farm expenses, adjusting for inventory changes and capital adjustments, and subtracting depreciation. Net farm income is a number that every farmer and rancher needs to calculate annually because it is the only way to determine the true profitability of your farm or ranch business.

Let's calculate net farm income for my example farm. Gross cash farm income was $163,652 and cash farm expense was $109,500, giving a net cash farm income of $54,152. Inventory changes and capital adjustment amounted to a positive $6,084 giving a net operating profit of $60,236. If this farm's annual depreciation of $29,078 is subtracted from net operating profit, you arrive at the $31,158 net farm income generated on this example farm. This tells the farm manager that his farm family earned $31,158 return for unpaid labor, management and equity capital.

Comparing your farm's financial performance to the average of a set of benchmark farms is the single most powerful farm and ranch management tool available, bar none. With this strategy, you use a comparative analysis to identify your farm's business strengths—areas where your farm's numbers beat the benchmark farms' averages. You also can use a comparative analysis to identify your farm's business weaknesses—areas where the benchmark averages are higher than your farm's numbers.

Where do you find benchmark averages to compare your farm or ranch data to? Many states have statewide farm business management associations that publish benchmark data. North Dakota, for example, summarizes accounting data from about 600 farmer and rancher members of farm management associations in an annual farm business management summary. This non-Red River Valley record summary makes an excellent set of North Dakota benchmark farms and ranches.

Minnesota, Kansas, Missouri, Iowa, Nebraska, Illinois, Indiana, Colorado, Kentucky, Tennessee, Oregon and Michigan are other states that publish farm business management association summaries that can serve as benchmark farms and ranches. I encourage you to contact your county extension agent to see what is available in your state.

North Dakota's benchmark farms were sorted on net farm income and grouped into three groups—the average of all farms, the average of the low-profit 20 percent, and the average of the high-profit 20 percent. How does my example farm's $31,158 earned net farm income compare to North Dakota's benchmark farm and ranches?

My example farm's $163,652 gross cash income was 83 percent of the benchmark farms' $196,853 average. This farm's $109,500 cash farm expenses was 68 percent of the benchmark average and was lower than the benchmark average, lower than the average of the low-profit group, and even lower than the average of the high-profit group. This farm's net cash farm income of $54,152 came through at 147 percent of the benchmark average but only 81 percent of the high-profit farms' average. While net cash income is a strength of this farm business, some farmers this year did even better.

It cost my example farmer 67 cents cash farm expense to produce each dollar of gross cash income. It cost North Dakota's benchmark farms 87 cents to generate each dollar of gross cash income. Clearly, this 67-cent cost of producing a dollar of gross income is one of my example farm's business strengths.

Net cash farm income, unfortunately, does not measure profitability. Inventory changes and depreciation have to also be taken into account to measure true profitability. The benchmark farms averaged a negative $7,922 inventory change implying that they had less inventory at the end of the year than they had at the beginning. The low profit farms had $36,773 less inventory at the end of the year while the high profit farms had $18,013 more inventory at the end of the year. My farm had a positive inventory change of $6,084.

Depreciation and capital adjustments averaged $13,689 on the benchmark farms while the example farm averaged $29,078—212 percent of the benchmark farms' average. Why is my example farm's depreciation and capital adjustment so much higher than the benchmark farms? Did this farmer buy too much new machinery?

Let's summarize the answer so far to the "Where Am I?" question for this example farm. My example farm's $31,158 net farm income is 205 percent of the $15,189 benchmark farms' average. Clearly, this example farm's earned returns to this family's three resources—unpaid family and operator labor, management and equity capital—is above the average of North Dakota's benchmark farms. Net farm income on the high profit benchmark farms, however, averaged another 122 percent higher net farm income than this example farm. While my example farm's earned net farm income was a business strength, North Dakota's high-profit benchmark farms did even better. There must still be room for improvement on this example farm. My next Market Advisor will analyze the capital invested in this farm business.

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Source: Harlan Hughes (701) 231-7380 hhughes@ndsuext.nodak.edu

Editor: Tom Jirik (701) 231-9629

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