In addition to getting a farm’s records ready for income tax preparation at the beginning of the year, it’s important for a farm to perform a financial checkup. One area that should be examined every year is profitability.
Several measures can be used to examine farm profitability. Two of the most commonly used are accrual net farm income and the operating profit margin ratio. Net farm income is used for family living, to repay debt, and to purchase new and used assets. This measure is extremely important to monitor over time on an individual farm, but because it depends on farm size, it seldom makes sense to compare net farm income numbers with other farms. The operating profit margin is more conducive to benchmarking profitability among farms.
Operating profit margin
The operating profit margin ratio is computed by adding interest expense and subtracting operator and family labor from net farm income, and dividing the result by value of farm production, which is a measure of gross income. Net farm income, interest expense and value of farm production can be obtained from the farm’s accrual income statement. Operator and family labor can be estimated using family living expenditures.
Including interest expense and operator and family labor in the computation enables us to compare farms with very little debt to high debt-to-asset farms, as well as farms with no hired labor to farms with a substantial proportion of labor derived from hired labor.
A long-term operating profit margin benchmark is 20%. This ratio has been difficult to achieve in the last few years. A benchmark for the last five years would be 12%.
Where profit goes
Let’s discuss what the 12% operating profit is used for. First, a positive operating profit margin signals that the farm had enough net farm income to cover both interest expense, and operator and family labor.
Second, for a farm with a low to modest debt-to-asset ratio, the 12% profit margin is likely large enough to cover principal payments on term debt.
Third, a 12% profit margin does not leave much room for used and new asset purchases. Not surprisingly, asset purchases during the last five years have been lower than what they were in the proceeding five-year period. To fully replace assets and expand the operation requires a long-term operating profit margin closer to 20%.
In today’s environment, it’s imperative to gauge a farm’s profitability. It’s very difficult, if not impossible, to determine the impact of changes in the operation if you don’t have a profitability baseline to compare to.
More information pertaining to income statements and the operating profit margin can be obtained on the website for the Center for Commercial Agriculture.
Langemeier is with Purdue University’s Center for Commercial Agriculture. He writes from West Lafayette, Ind.