What does managing for financial success mean to you?
Is it simply a function of more and more money? If that resonates for you, and you own farmland in Western Canada, your “success” — your wealth — will have increased substantially over the past 10 years as farmland values soared.
But then, we all know that there’s more to understand about farms and wealth. Wealth tied up in land is good to have. Short of a decrease in land values, that form of wealth is not going anywhere. Wealth tied up in depreciable assets such as equipment isn’t an ideal place to retain wealth in a farm, but it’s necessary.
A challenge with wealth in land and depreciable assets is that it’s not easily available.
Wealth in actual cash and marketable inventory, on the other hand, is readily available. You use it to operate the farm. It’s available when you need it until it’s not because that form of wealth can erode relatively quickly if weather and markets work against you.
There is history in a scenario of rapidly rising commodity values — price spikes, as they are known. The price spikes are short-lived and followed in relatively short order by increases in input costs and land and equipment costs.
The commodity prices tend to retract quickly, leaving higher input costs and narrow or no margins. Land and equipment bought and financed at those higher values results in greater demand for cash flow. The higher costs of inputs and capital assets, coupled with lower commodity prices, correlates to higher risk profiles.
Making the scenario even more challenging is the duration of lower commodity prices and narrow margins. It doesn’t take long before the readily available wealth disappears.
If you’ve been fortunate and have had favourable weather the past couple years, you may have reported once-in-a-lifetime type profit margins. A question I’ve been asked several times this winter has to do with that scenario. How can you measure the potential impact of declining margins?
My suggestion is to tie profit margins to risk thresholds associated with commitments to meet principal and interest payments obligations that are associated with higher capital costs and higher interest rates. Obviously, those debt obligations do not decrease as profit margins shrink with decreasing commodity prices.
Here’s a way to gain an understanding of your exposure:
1. Calculate your operating efficiency margin (OEM) ratio for your most recent year.
2. Calculate your past five-year operating efficiency margin ratio.
3. Calculate the percentage increase in your current year operating efficiency ratio over the five-year average. (Note that by using the operating efficiency ratio, you do not factor depreciation or interest costs into the analysis.)
• OEM 2022: 40.3%
• OEM avg. past five years: 20.8%
• OEM difference (increase): 51.6%
4. Now, calculate your debt servicing ratio for your most recent year.
5. Then calculate what your current debt servicing ratio would be if your operating efficiency margin was to decrease, with lower commodity prices, to your five-year average operating efficiency margin.
• Debt servicing ratio 2022 — 3.93–1 (That’s $3.93 for every $1 of principal and interest)
• Debt servicing ratio at 51.6% less 2.02-1 (51.6% of 3.93)
• The analysis provides you with your sensitivity to profit margin erosion as a function of your principal and interest repayment obligations.
• A general industry benchmark is to have a debt servicing ratio of 2 to 1 or greater. In the example above, at 2.02 to 1, this farm is in good shape as margins retract.
• Any value greater than 1.5 to 1 would be generally acceptable. As the value falls increasingly lower than 1.5 to 1, sensitivity to profit margin erosion increases.
• If a situation on your farm exists where the value falls to 1.25 to 1 or lower, you need to take action right away.
It’s important to keep in mind that the calculations above should provide you with context for your financial strengths and weaknesses. The calculations and ratios do not make the decisions for you.
If you wanted to create a more conservative perspective, rather than using the past five-year average OEM, use the previous five years. By doing this, the 2022 year result is not increasing your average.
You can use other metrics to measure sensitivity to declining margins. A couple of other ratios to examine would be working capital percentage and gross margin ratios.
Working capital percentage ratio provides you with sensitivity to cash flow decline. Gross margin ratio provides you with sensitivity to decreases in financial efficiency.
I think these types of calculations are important and might be helpful when you want to get perspective on your sensitivity to declining profit margins.
If you don’t know how to make these calculations and interpret the results, find someone who can help you.
Making future decisions about capital investment and taking on more debt without understanding how sensitive you are to profit margin erosion can be risky.
If you would like to speak to one of our consultants about this topic contact us.