The economics of agriculture appear to have a surprise around every corner. Uncertainty regarding the North American Free Trade Agreement (NAFTA) has lowered prices on milk, beef, pork, and poultry. Other trade issues have taken the glow off soybeans. The price disruptions caused by these issues add to already suppressed margins. The agriculture industry is experiencing a downturn nearly as pronounced as the golden economic years preceding it. To provide some credence to these statements, let’s dive back into the FINBIN database. The FINBIN database collects information across 20 states and from thousands of farmers, who tend to be above average. We will examine how these variables are affecting margins for above average, average, and below average producers in the database.
One of my all-time favorite ratios from the Farm Financial Standards Council is the operating expense to revenue ratio. This ratio is calculated by dividing total operating expenses by total revenue and is expressed as a percentage. Interest expense is excluded from total operating expenses because not all farmers borrow money and incur interest expense. Depreciation is also excluded from the calculation because the various methods to calculate depreciation can distort the data, particularly accelerated depreciation schedules.
The average farm in the FINBIN database reported an 83 percent operating expense ratio. This means that the average producer required $0.83 of expenses to produce $1.00 of revenue. This leaves less than $0.17 left over for debt service, family living expense, capital expenditures, and income taxes. This ratio is elevated approximately 15 percent over the level reported during the commodity super cycle, otherwise known as the golden years of agriculture.
A closer look at the top 20 percent of producers finds better results with the operating expense ratio in the 75 percent range. However, this is significantly above the average ratio of 60 to 65 percent reported by this group during the golden years.
The below average or bottom 20 percent of producers require $0.96 to produce $1.00 of revenue. This has been a consistent pattern for this group of producers since the beginning of the agriculture economic reset.
The operating expense ratio can be improved by either a reduction in expenses or an increase in income. As farm income continues to be stressed by trade issues and price volatility, many producers are cutting expenses to improve their bottom line. This ratio needs to be on your dashboard as the downturn continues!
One variable not closely examined in recent years is the interest expense to revenue ratio. While this metric is below 6 percent across all farms in the database in 2017, a rise in interest rates with smaller margins could be a combustible mix.
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