Profitability as a financial measure

Profitability measures the extent to which a business generates a profit from the factors of production: labor, management and capital. Profitability analysis focuses on the relationship between revenues and expenses and on the level of profits relative to the size of investment in the business.

Four useful measures of farm profitability are the rate of return on farm assets (ROA), the rate of return on farm equity (ROE), operating profit margin and net farm income.

The ROA measures the return to all farm assets and is often used as an overall index of profitability, and the higher the value, the more profitable the farm business.
The ROE measures the rate of return on the owner’s equity employed in the farm business. It is useful to consider the ROE in relation to ROA to determine if the farm is making a profitable return on their borrowed money.

The operating profit margin measures the returns to capital per dollar of gross farm revenue. Recall, the two ways a farm has of increasing profits is by increasing the profit per unit produced or by increasing the volume of production while maintaining the per unit profit. The operating profit margin focuses on the per unit produced component of earning profit and the asset turnover ratio (discussed below) focuses on the volume of production component of earning a profit.

Net farm income comes directly off of the income statement and is calculated by matching farm revenues with the expenses incurred to create those revenues, plus the gain or loss on the sale of farm capital assets. Net farm income represents the return to the farmer for unpaid operator and family labor, management and owner’s equity. Like working capital, net farm income is an absolute dollar amount and not a ratio, thus comparisons to other farms is difficult because of farm size differences.

Repayment capacity measures the ability to repay debt from both farm and non-farm income. It evaluates the capacity of the business to service additional debt or to invest in additional capital after meeting all other cash commitments. Measures of repayment capacity are developed around an accrual net income figure.

The short-term ability to generate a positive cash flow margin does not guarantee long-term survivability. Long-term survivability requires the farm to be profitable. The only way for an unprofitable farm to survive long-term is for income infusions from non-farm sources to offset farm losses. These cash infusions usually come from off-farm employment, inheritances and gifts or from a lender if the farm assets appreciate faster than the farm is losing money and the farmer can successfully refinance the farm’s debts.

Two measures of repayment capacity are the term debt and capital lease coverage ratio and the capital replacement and term debt repayment margin. The term debt and capital lease coverage ratio provides a measure of the ability of a borrower to cover all required term debt and capital lease payments. The higher the ratio is over 1:1, the greater the margin to cover the payments. Higher ratio values also indicate greater flexibility on the part of the farmer to withstand and adjust to temporary adverse economic conditions. Even though the farm may be generating sufficient accrual earnings to cover all term debt and capital lease payments, there may not be sufficient cash to make the payments on a timely basis; thus cash flow analysis is needed as well.

The capital replacement and term debt repayment margin is used to evaluate the ability of the borrower to generate funds needed to service existing term debts and replace capital assets. It also enables users to evaluate the ability to acquire additional capital, service additional term debt and to evaluate the risk margin.

Financial efficiency measures the degree of efficiency in using labor, management and capital. Efficiency analysis deals with the relationships between inputs and outputs. Because inputs can be measured in both physical and financial terms, a large number of efficiency measures in addition to financial measures are usually possible.

Five measures of financial efficiency are the asset turnover ratio, operating expense ratio, depreciation expense ratio, interest expense ratio and net farm income from operations ratio. The asset turnover ratio measures how efficiently farm assets are being used to generate revenue. The higher the ratio, the more efficiently assets are being used to generate revenue.

The last four efficiency measures are operating ratios accounting for the composition of gross farm revenues. The sum of the operating expense ratio, depreciation expense ratio and interest expense ratio reflects the total direct farm expenses per dollar of gross farm revenue for each component—operating, interest and depreciation. Note that the operating expense ratio standards will vary between types of farms and operating systems. Taken together, these four ratios represent the total composition of gross revenues and in percentage terms accounts for 100 percent of the farms’ gross revenues.