Improving Financial Performance: What Is the Payoff?

Objectives

• Understanding determinates of operating performance (ROA)

• Understanding determinates of financial performance (ROE)

• Links between managerial decisions and financial performance

Determinants of Operating Performance (ROA)

• Operating profit margin• Asset turnover ratio

Operating Profit Margin

Turnover Ratio

Return on AssetsX =

Determinants of Financial Performance (ROE)

• Operating profit margin• Asset turnover ratio• Leverage

Return on Assets

Interest Assets

Leverage ROE- X =

Profitability Analysis

AKA The DuPont Model

DuPont AnalysisOperating Performance

GrossRevenue

FixedCosts

VariableCosts

Net Income

- - =

Total AssetsGross

RevenueTurnover

Ratio=÷

ROAx

InterestExpense

Net Income

GrossRevenue

Operating Profit Margin+ ÷ =

Total Assets EquityFinancial Structure=

Financial Structure

÷

ROE

InterestAssets-

x

Implications

• If ROE > ROA– Interest rate less than ROA– Making money on borrowed money– Increase ROE by borrowing more (but be careful)

Implications

• If ROE < ROA– ROA less than interest rate– Losing money on borrowed money– Reduce interest cost– Reduce debt– Improve operating performance (ROA)

Improving performance• Ways to enhance operating performance (ROA)

– Increase operating profit margin– Increase volume per dollar invested or capital turnover

• Ways to enhance equity return (ROE)– Enhance operating performance– Reduce financing costs– Leverage – more debt

Data for Profit Analysis1. Gross Revenue

2. Fixed Costs

3. Variable Costs

4. Interest Costs

5. Total Assets

6. Equity

Income Statement

Balance Sheet

Example Case: MBC Farms

• Operated by Mike, Betty, and Craig• Enterprises

– Crops, dairy

• Operate 3,000 acres, 250 milking cows– Own 1,800 acres, cash rent remainder

• Six full-time employees

Worksheet 1: Cost Basis InputsSchedule F Data Taxable Year: X4

Cost of livestock sold (Schedule F, line 21) A -$ Gross revenue (Schedule F, line 11 or A of income statement2) B 1,432,549$ Depreciation (Schedule F, line 16 or "use cost" number from income statement)

C136,922$

Mortgage interest (Schedule F, line 23a) D 89,808$ Other interest paid (Schedule F, line 23b) E 11,788$ Total expenses (Schedule F, line 35 or B of income statement + depreciation or "use cost" number)

F1,517,050$

Balance Sheet Beginning EndingBalance sheet date 12/31/X4 12/31/X5

Cash G 157,689$ L 5,016$ Total current farm assets H 337,747$ M 485,376$ Total current farm liabilities I 252,136$ N 321,867$ Accrued Interest J 16,968$ O 14,088$ Farm accounts payable and accrued exp. K 4,169$ P 6,131$ Total farm assets (remove all nonfarm real estate) Q 2,408,799$ Total farm liabilities (remove all nonfarm liabilities) R 1,121,439$ Owner's equity S 1,287,360$

Miscellaneous DataBreeding stock sales (Form 4797) T 63,800$ Number of operators and employees (annual full-time equiv.) U 9Family living expenses3 (all families supported by the farm) V 150,000$

Net Farm IncomeGross revenues [A+B+T+(M-L)-(H-G)] W 1,796,651$ Interest expense [D+E+(O-J)] X 98,716$ Other expenses [A+F-(D+E)+(P-K)] Y 1,417,416$ Net farm income [W-X-Y] Z 280,519$

Worksheet 4

Spreadsheet for MBC Farms Case

Worksheet 4: MBC Farms (cost value)

Financial Data

1. Gross Revenue$1,796,651

2. Fixed Costs 385,638

3. Variable Costs 1,280,494

4. Net Income 130,519

5. Total Farm Assets 2,408,799

6. Owner's Equity1,287,360

7. Interest Expense98,716

Complete Worksheet 4

Worksheet 4: MBC Farms (cost value)

Operating Profit Margin

12.8%

Asset Turnover Ratio 74.6%Return on Assets 9.5%Interest Cost of Assets 0.041Financial Structure 1.87

Return on Equity

10.1%

Worksheet 4: MBC Farms (market value)

Operating Profit Margin

12.8%

Asset Turnover Ratio 38.6%Return on Assets 4.9%Interest Cost of Assets 0.021Financial Structure 1.32Return on Equity 3.7%

Reduced interest

• Opportunity to refinance term debt at a 1% lower interest rate

• $91,648 in intermediate debt and $799,573 term

• Saves about $8,913

Complete Alternative on Worksheet 4

Reduced InterestActual Projected

1. Gross Revenue$1,796,651 $1,796,651

2. Fixed Costs 385,638 376,725

3. Variable Costs1,280,494 1,280,494

4. Net Income 130,519 139,432

5. Total Farm Assets

2,408,799 2,408,799

6. Owner's Equity 1,287,360 1,287,360

7. Interest Expense

98,716 89,803

Reduced Interest Results

Actual Projected

Operating Profit Margin 12.8% 12.8%Asset Turnover Ratio 74.6% 74.6%Return on Assets 9.5% 9.5%Interest Cost of Assets 0.041 0.037Financial Structure 1.87 1.87

Return on Equity 10.1 10.8%

Earlier soybean planting

• Has been planting about half of soybeans after June 23

• Pushing harder would result in about a 10% increase in soybean revenue

• No change in costs

Earlier PlantingActual Projected

1. Gross Revenue$1,796,651

$1,832,087

2. Fixed Costs 385,638 385,638

3. Variable Costs1,280,494 1,280,494

4. Net Income 130,519 165,956

5. Total Farm Assets

2,408,799 2,408,799

6. Owner's Equity 1,287,360 1,287,360

7. Interest Expense

98,716 98,716

Earlier Planting ResultsActual Projecte

dOperating Profit Margin 12.8% 14.4%Asset Turnover Ratio 74.6% 76.1%Return on Assets 9.5% 11.0%Interest Cost of Assets 0.041 0.041Financial Structure 1.87 1.87Return on Equity 10.1 12.9%

Summary

• Measurement of performance– Operating: ROA– Financial: ROE

• Determinants of rates of return– Operating profit margin– Asset turnover ratio– Cost of debt– Leverage

• Links among managerial decisions & rates of return

Key Points?

• What are the 2 key elements of operating performance?

• Overall financial performance is measured by what ratio?

• With respect to financial performance, when is debt a good thing?

References

• Boehlje, Michael, Craig Dobbins, Alan Miller, Dawn Miller, & Freddie Barnard, Measuring and Analyzing Farm Financial Performance, Department of Agricultural Economics, Purdue University, EC-712, 1999 (pages 37-43),

• Miller, Alan, Michael Boehlje, and Craig Dobbins, Key Financial Performance Measures for Farm General Managers, Department of Agricultural Economics, Purdue University, ID-243, June 2001.

Strategic Business Planning for Commercial Producers

Worksheet 4

Financial Data MBC Farms

1. Gross Revenue

2. Fixed Costs

3. Variable Costs

4. Net Income

5. Total Farm Assets

6. Owner's Equity

7. Interest Expense

Reduced Interest Results

Actual Projected

Operating Profit Margin 12.8%Asset Turnover Ratio 74.6%Return on Assets 9.5%Interest Cost of Assets 0.041Financial Structure 1.87Return on Equity 10.1

Earlier Planting ResultsActual Projecte

dOperating Profit Margin 12.8%Asset Turnover Ratio 74.6%Return on Assets 9.5%Interest Cost of Assets 0.041Financial Structure 1.87Return on Equity 10.1