Conducting a farm financial performance or financial benchmarking analysis can be daunting to those unaccustomed to doing them. If we are lucky enough to have the minimum number of financial documents needed to conduct a meaningful financial analysis (both beginning and ending balance sheets, either an actual accrual or accrual adjusted income statement, and a statement of cash flows), we are then inundated with pages and pages of intimidating numbers to sort through.
This gives many managers and advisers a justification not to give their financial records anything more than a passing glance. This is unfortunate. A good financial performance analysis should do more than inform about how a farm performed in the past. More important, it should provide the manager and adviser with insight regarding how to prioritize activities that will enable the farm to improve its financial performance.
In this article, I would like to present my preferred method of financial performance analysis, the DuPont Analysis. Notice that I wrote “my preferred method.” It is an important distinction, as there are many methods of financial analyses, and, unfortunately, none are perfect. All financial performance analysis methods have their strengths and weaknesses. Nevertheless, I prefer the DuPont Analysis because, in a relatively short amount of time, the manager or adviser can determine if they need to emphasize price, yield, asset utilization, and/or cost efficiency issues in order to improve farm financial performance.
The DuPont Analysis links a farm’s Rate of Return on Assets (ROROA) to two other ratios, the Asset Turnover Ratio (ATO) and the Operating Profit Margin (OPM)1 by the following equation:
ROROA = ATO * OPM.
Please note, because the DuPont Analysis is asset-based, it is important that the same asset valuation method (cost basis, agricultural use market value, or pure market value) be used for both the farm and the benchmark standards. This doesn’t mean that each similar asset has to carry the exact same value to have a meaningful analysis. Nevertheless, it does mean that the overall appraisal method used to value the farm and benchmarks should be the same. For example, you want to avoid comparing a farm that uses a cost basis approach of valuing assets with a benchmark standard that uses a pure market value approach.
When comparing a farm to benchmark performance values, if a farm’s ROROA is low because of a low ATO, the manager or adviser knows that the performance differences are due to price, yield, or asset utilization issues. If this were a dairy farm, the manager or adviser would then want to compare such measures as the average milk price received, milk shipped per cow, and assets per cow. The manager or adviser would then prioritize correcting the problem area(s). For example, if a dairy farm manager determined that the ATO was low due to average milk price received, then the manager knows that he or she should prioritize actions that will help improve milk price (better market planning, better milk quality, better components, etc.).
If, however, the low ROROA was caused by a low OPM, then the manager or adviser knows that the difference was caused by cost efficiency issues. The manager or adviser of a dairy farm would then want to compare the farm’s cost items (feed, veterinary, fertilizer, labor, repairs, depreciation, interest, etc.) with those of the benchmark. The comparison should be done on a per hundredweight, hundredweight equivalent, or, better still, as a percentage of gross farm revenue or total farm income. If, for instance, the manager discovered that the farm’s repair expenditures as a percentage of gross farm revenue were too high, the manager should investigate, among others, such things as buying/leasing newer equipment, improving their operator training program, and/or examining their maintenance protocols.
Of course, there are times when the ROROA is low due to both ATO and OPM issues. Nevertheless, by following the previously mentioned procedures, the manager or analyst can determine which price, yield, asset utilization, and cost efficiency items would have the biggest impact of farm financial performance and prioritize their farm activities accordingly.
If you have not used the DuPont Analysis when doing a financial performance analysis, I encourage you to give the method a try. I believe you will find it very efficient at getting to the root of farm financial performance problems.
1ROROA = [(Net Farm Income from Operations + Interest – Unpaid Labor)/(Average Total Farm Assets)]*100%
ATO = (Gross Farm Revenues or Total Farm Income)/(Average Total Farm Assets)
OPM = [(Net Farm Income from Operations + Interest – Unpaid Labor)/(Gross Farm Revenue or Total Farm Income)]*100%
University of Wisconsin-River Falls, UW-Extension, and the Center for Dairy Profitability