Profitability in Farming: Rates of Return and Comparison

Profitability in Farming: Rates of Return and Comparison to Other Industries (I-E)

Paper presented at Statistics Canada’s Economic Conference May 9 – 10, 2005

John Caldwell, Agriculture and Agri-Food Canada (613-759-1923) Paul Murray, Agriculture Division, Statistics Canada (613-951-0065)

Profitability in Farming: Rates of Return and Comparison to Other Industries

Abstract Traditionally rates of return in the agriculture sector have been calculated on the market value of the assets as opposed to the historical cost. In other sectors rates of return are calculated on the basis of the historical cost of the assets which has meant that rates of returns in agriculture are not comparable to those in other sectors. This paper calculates rates of return for incorporated farms, based on the historical cost of the assets and compares these rates of returns to those in other sectors. It also measures the impact of capital gains on the rates of return for the agriculture sector. In the final section of the paper we measure the level of risk with the rates of return both in the agricultural sector and in other sectors. Introduction In the past, the industry has often focused on realized net income1 as the traditional measure of profitability in the agriculture sector. Realized net income is an aggregate measure of the level of income and is an important measure in relative terms in determining if the level of profitability is increasing or decreasing. However, we need to develop other measures of profitability. One important measure of profitability that has been lacking in the agriculture sector is to measure the profitability against the level of investment. For example, it would be unreasonable to buy a farm for $250,000 and expect to realize a net income of $50,000 per year. To do so would mean that the investor is making a annual return of 20% which would be unusual given that current deposit rates are under 5%. If this were the case then everyone would want to farm to the point where the assets were bid up and the return was reduced to more reasonable return of 5% which is comparable to similar investments. To make this level of return we would expect that an investment of $1,000,000 would be more reasonable. In other words the absolute level of profitability should be measured in proportion to the level of investment. Two of the more common measures of the profitability of a business are the Return on Assets and Return on Equity. These ratios measure the income from the business in proportion to the original cost of the investment. Most sectors use generally accepted accounting principles when reporting their financial position, including the use of balance sheets and income statements. Assets used in producing the calculation of the return on total assets and the return on equity are based on historic cost of these. In the case of the agriculture sector most farm businesses are unincorporated and do not 1 Realized net income measures the financial flows, both monetary (cash income) and non-monetary (depreciation and income in kind), of farm businesses. It is calculated by subtracting operating expenses from gross revenue, then adding income in kind and subtracting depreciation.

produce a balance sheet on a regular basis. When farmers do produce a balance sheet it is generally used for the purpose of obtaining credit and as a result the assets are valued at market to be used as security for the loan. Due to the absence of a balance sheet at historical cost, the return on assets and on equity when calculated for farm businesses have been calculated on the assets or equity valued at market value. In doing so, we have created two problems: - the return is not comparable to other sectors and - the rate of return is understated because the market value is usually greater than the historical

cost. The following example shows the difference in the two methods of calculation on the return on assets. A farmer buys a farm in 1980 for $500,000. The current market value of the farm in 2000 is $1,000,000. The net income from the farm after taxes was $50,000 in 2000. - the return on assets based on the market value is $50,000/$1,000,000 = 5% - the return on assets based on the cost of these assets is $50,000/$500,000 = 10% This raises a second question of what to do about the capital gains of $500,000 ($1,000,000 - $500,000) which have been earned over the 20-year period from the appreciation of the assets. To answer this question we need to look at the stock market to see how returns are calculated when investing in a stock. If we had invested in a stock which was purchased in 1990 for $100 and sold in 1995 for $200 our return would be ($200 - $100)/$100 = 100% over 5 years or 20% per year. If the stock had paid a dividend of $5 each year then this would be an additional return of 5% per year. Adding the two together, we get a total return on our investment of 25% (20% + 5%).

Figure 1: Price of farmland and buildings, $/acre, 1971 to 2001

0

100

200

300

400

500

600

700

800

900

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Year

$/acre

Source : Statistics Canada, Value of Farm Capital – Agriculture Economic Statistics, catalogue no. 21-013-XIE. In most other sectors, assets depreciate in value. This is particularly true in the natural resource based industry such as mining and forestry. In fact once the trees are cut or the minerals are mined there is often a negative cost associated with the asset due to environmental factors. Agriculture is different in that farmland for the most part does not depreciate in value and in fact over the long term increases in value as shown in Figure 1. This shows that investing in farmland is very similar to our stock example. The net income from farming is similar to the dividends received each year and the increase in the price of the stock is similar to the capital gain on the land and buildings. Quota has not decreased in value to date as shown in Figure 2. Thus, any eligible capital expenditure deducted as an expense for quota will be recaptured when the quota is sold. In the case of quota we have not only included the capital gain but we have also added to the capital gain the eligible capital expenditure deducted for the year which will be recaptured when the quota is sold.

Figure 2: Value of quota reported by dairy farms, 1991 to 2002

0

2

4

6

8

10

12

14

16

18

1991 1993 1995 1997 1999 2001 2002

Year

$ Billion

Source: Statistics Canada, Farm Financial Survey, catalogue no. 21F0008XIB.

Literature review Much has been written about profitability in primary agriculture and other industries that form the agri-food chain, both in Canada and internationally. There are a large number of possible ways to measure profitability in any industry, and again, the literature is abundant on strengths, weaknesses and conceptual nuances of different options. Since almost all of the studies on primary agriculture calculate rates of return based on market values and this paper focuses on calculating returns using historical costs, only selected papers relating closely to the theme of this paper will be discussed in any detail in this section. International conceptual frameworks exist for measuring agriculture’s contribution to Gross Domestic Product. The revision to the United Nations’ System of National Accounts in 1993, (SNA 93) for example, outlines the structure of accounts such as the production account, the generation of income accounts and the entrepreneurial income account. Similarly, the European Union’s revised methodology for the Economic Accounts for Agriculture in 1997 (EAA 97) has been adopted by the OECD as the basis for its data-gathering from OECD countries, and provides a basic structure for measuring aggregate agricultural economic data. In its Agriculture Economic Statistics publication series, Statistics Canada calculates three measures of aggregate net farm income for the sector: net cash, realized net and total net income (using internationally recommended concepts for producing agricultural economic accounts). In addition, the agency produces a value added account, a cash flow statement and a balance sheet that is accompanied by a number of ratios relating to liquidity, solvency, profitability and financial efficiency. The balance sheet and ratios were formatted based on recommendations from the Farm Accounting Standardization Review Committee of the Farm Credit Corporation, 1991. While together this diverse series of integrated accounts produce a very useful picture of the health of the industry in Canada, assets are priced at market value so comparisons with other industries where book values from financial records are used are not relevant. In addition, Statistics Canada’s quinquennial Census of Agriculture and its annual Farm Financial Survey also collect survey information on assets of farm operations at market values that permit analysis at the farm level. The aggregate approach used by Statistics Canada is common to many other countries with well-developed agricultural statistical systems. The Economic Research Service of the United States Department of Agriculture, for example, produces both aggregate measures of value added and net income and also analyses data at the farm level. Vogel and Johnson (2000) discuss how survey questions have been tailored to allow measures calculated to adhere to the desired concepts. Assets are valued at market prices in aggregate balance sheets. Morehart, Nielsen and Johnson (1988) developed a set of four financial ratios to be used in monitoring and comparing the financial performance of U.S. farm businesses using data from the 1986 Farm Costs and Returns Survey. They noted that the financial ratios measuring solvency, liquidity and coverage, efficiency and profitability can give farmers, lenders, investors, analysts and policymakers a more complete perspective on the performance of a farm or group of farms and may help identify actions to modify performance.

As mentioned above, many countries have also attempted to develop standards for measuring profit and returns at the farm level. In the United States, the Farm Financial Standards Council, in 1997, reported on several diverse measures, both absolute and ratio, and recommended using one of the following: rate of return on farm assets, rate of return on farm equity, operating profit margin ratio and net farm income. This council evolved from an agricultural conference held by the American Bankers Association in 1989 whose goal was to develop realistic uniform accounting standards and financial measurements for agricultural operations. One of the primary objectives in this study is to be able to compare the rates of return in the primary sector to rates of return in other sectors. It would be difficult and a lot of extra work to take financial information from other sectors and make it conform to the financial data from the primary sector. Thus, the only feasible solution is to accept the financial data from other sectors as is and then calculate rates of returns for the primary sector in a comparable manner. Calculating rates of return is not new. It has been done in other sectors for years and there are a number of proven methods available. If you take any business finance text book and look up ratio analysis, you will find numerous ratios explained and defined. These ratios are usually classified into such categories as:

- profitability ratio, - asset utilization ratio, - liquidity ratios and - debt utilization ratios.

For the purpose of this analysis we are interested in the profitability ratios which include profit margin, return on assets, and return on equity. The profitability ratio is equal to net income divided by sales. The return on assets is calculated by taking net income divided by the total assets. The return on equity is calculated by taking net income divided by the owner’s equity. The only question in the analysis appears to be what to do about the interest expense. Some of the authors view interest expense as part of the return to those assets that were financed by debt and because it was deducted as an expense in calculating net income it should be added back into net income in order to calculate the return on assets. However, in the case of the return to equity it is generally agreed that the interest expense is not part of the return to equity and thus, should be deducted as an expense. Based on the foregoing then the most relevant literature is concerning profitability measures in the food processing industry. Deloitte and Touche have been tracking financial performance for several years in both Canada and the United States. This work examined earnings before tax and extraordinary items expressed as a percentage of net sales, and return on assets and equity both before tax and extraordinary items in order to eliminate any differences in the treatment of income taxes. In the case of the return on assets they chose not to add interest back into the net income figure. In the study entitled Performance in the food retailing sector of the agri-food chain, Smith and Trant looked at three measures of profitability. The first method is gross margin which they rejected because it is influenced by sales volume. The second measure they examined is the

return on equity which was rejected because it is influenced by the “financial structure of the firm”. The third measure which they used was a variation of the return on assets. In their calculation of operating income they excluded interest and taxes. However, instead of dividing by total assets they used long term capital in order to measure the return on long term investments. Most sectors would not calculate a return on long term capital but, rather total assets. Thus, for the sake of comparability we should use total assets. Burroughs et al., 2001, and Burroughs and Harper, 2002, examined returns on investment for businesses (food manufacturers, food wholesalers and food retailers) operating in the Canadian food sector during the 1990s using the same methodology as Smith and Trant, 2002.

Data and methods Under the Canadian Income Tax Act, incorporated farms are required to file for the business, at the end of each fiscal year, an income statement and a balance sheet with the assets valued at their original cost. Statistics Canada has collected a representative sample of farm tax returns each year since 1991 and has provided estimates of the population. In order to eliminate any small farms in our analysis, we have only used incorporated farms with $50,000 or more in revenue. In 2001, Statistics Canada estimated that there were 24,480 incorporated farms with revenues of $50,000 or more based on a sample 11,205 incorporated farms. In the case of unincorporated farms and partnerships, only wages and salaries paid to hired help, the children and the spouse can be deducted as an expense under the tax act. However, in the case of incorporated farms, wages and salaries paid to the owner can also be deducted as an expense. Thus, in this analysis because we are only using incorporated farms, wages and salaries to the owner have been deducted as an expense. This means that net income is the return to capital. Farms were classified into various farm types if 51% of their revenues were derived from one sector. For our analysis we will calculate the return on total assets and the return on equity for grain and oilseed (grain farms), dairy and hog farms for the eleven-year period from 1992 to 2002. To calculate the return on total assets we took the Net Operating Income as reported for tax purposes and added back the reported Interest Expense. From this total we deducted the reported Capital Cost Allowance (CCA) and in the case of dairy farms we also deducted the Allowance on Eligible Capital Property (ECE). This total was then divided by the total value of the assets at cost as reported on the Balance sheet. Return on Total Assets = Net Incomet – CCAt- ECEt + Interest Expenset Total Assetst-1 The Return on Total Assets was further broken down based on the two sources of revenue: Returns from Market = Net Incomet – CCAt - ECEt + Interest Expenset - Program Paymentst Total Assetst-1 Returns from Program Payments = Program Paymentst Total Assetst-1 To calculate the return on equity we took the Net Operating Income as reported for tax purposes and deducted the reported Capital Cost Allowance (CCA) and in the case of dairy farms we also deducted the Allowance on Eligible Capital Property. This total was then divided by the net worth at historical cost as reported on the Balance sheet. Return on Equity = Net incomet – CCAt - ECEt Net Wortht-1

To estimate the return from the capital gain on the assets we used the Farm Financial Survey (FFS) which was collected every second year and collects the value of assets based on market value. We extrapolated the asset values for the missing years using the straight-line method. In 2002 the balance sheet information for corporate farms was no longer collected and thus, we are only able to calculate the capital gains for the ten-year period from 1992 to 2001.2 The land and buildings are reported as one value. Thus, we can not measure the decrease in buildings due to wear and tear. However, any decrease in the value of the buildings will be offset in the total by the increase in the value of the land in the total value and thus will not affect the measure of the capital gain. In order to measure the capital gain of the asset we have taken the market value in year (t). From this we subtracted the historical cost of the assets from the balance sheet information as reported in the corporate tax filer data base for year (t). This measures the capital gain in the value of the asset over the life of the asset. In order to measure the annual capital gain we subtract from this figure the market value in year (t-1) net of the historical cost in year (t-1). Results Current return on assets – In Figures 3, 4 and 5, we have calculated the rate of return on assets for grain, dairy and hog farms respectively at market value (lower line) compared to the rate of return at historical cost (top line). In all cases the rate of return is higher based on the historical cost than is the case when the assets are valued at market value. In the case of grain farms both the return on assets and the return on equity peaked in 1996 and bottomed out in 1999. Since 1999 it has been increasing but still remains below the peak in 1996. The average return on assets for grain farms is 5.0% compared to 5.3% over the same period for dairy farms, a supply-managed sector. In the case of hog farms the return on assets averaged 4.6% over the eleven-year period. The return on assets at market value for hog farms is slightly lower averaging 3.7% between 1992 and 2002. It is only when the rate of return increases that the two lines move apart. This would suggest that, when prices are depressed, the historical cost of the assets and the market value are almost equal because hog barns are so specialized that they are only of value to another hog farmer.

2 In the 2001 reference year the FFS had a sample of 3,383 incorporated farms with revenue of $50,000 or greater which is weighted up to give a population estimate of 22,650 farms.

Figure 3: Current return on assets – grain farms

Figure 4: Current return on assets – dairy farms

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Percent

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Y ear

P er cent

Return to assets – Cost

Returns to assets – Market value


Returns to assets – Market value

Figure 5: Current return on assets – hog farms

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Percent

Current return on equity – In Figures 6, 7 and 8 we have calculated the rate of return on equity for grain, dairy and hog farms respectively at market value (lower line) compared to the rate of return at historical cost (top line). The return on equity for grain farms peaked at over 11.0% in 1996 and has averaged 6.3% over the eleven-year period compared to an average of 6.2% for dairy farms for the same period. In the case of hog farms the return on equity averaged 3.6% over the eleven-year period. It should be noted that the return on equity for hog farms is lower than their return on assets, which would suggest that hog farms in some years are not covering all their interest costs, thus reducing their return on equity.

Figure 6: Current return on equity – grain farms

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002Ye a r

P e r c e nt


Return to assets – Market value

Return to equity – Cost

Return to equity – Market value

Figure 7: Current return on equity – dairy farms

Figure 8: Current return on equity – hog farms

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Percent

Current return by source – In Figures 9, 10 and 11, we have calculated the rate of return on assets for grain, dairy and hog farms respectively from the market (lower line) and from program payments. The top line is the current return based on historical cost and the difference between the top line and the bottom line is the current return from program payments. You can see the impact that program payments had on the rate of return for grain farms in the early nineties.

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Y ear

P er cent

Return to Equity – Cost

Return to Equity – Market Value

Return to equity – Cost

Return to equity – Market value

Over the period 1992-2002 the return to the assets from the market for grain farms averaged 1.0%. The return on assets from program payments averaged 4.0%. Over the same period the return to the assets from the market for dairy farms averaged 3.3%. The return on assets from program payments averaged 2.0%. In the case of hog farms the difference is even more significant. The return on assets from the market place only averaged 0.2% over the period compared to a return on assets from program payments of 4.4%.

Figure 9: Current return on assets by source – grain farms

Figure 10: Current return on assets by source – dairy farms

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Percent

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Ye a r

Current return to assets

Current return to assets from market



Figure 11: Current return on assets by source – hog farms

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Percent

Returns from capital gains – Agriculture is different from many other natural resource-based industries such as mining and forestry, in that farmland for the most part does not depreciate in value once a harvest or other uses take place, and in fact over the long term increases in value. In Figures 12, 13 and 14, we have shown the rate of return on assets from the capital gain on land and buildings and, in the case of dairy, quota as well. The return from capital gains for grain farms tends to follow grain prices as evidenced by the peaks in the mid nineties. Most hog farms no longer have a large land base and now depend on purchased feed. The result is that capital gains is not a significant factor in the hog sector and because most of the gain is realized on the hog barn it tends to fluctuate with a lag in the short term in the same manner as hog prices.

Figure 12: Return on assets from gain on land and buildings – grain farms



-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Return to assets - Land and buildings

Figure 13: Return on assets from gain on quota, land and buildings – dairy farms

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Figure 14: Return on assets from gain on land and buildings – hog farms

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Return to assets –Land , buildings and quota

Return to assets – Land and buildings

Return to assets – Land and buildings

In Figures 15, 16 and 17, we have shown the capital gains as a rate of return on equity. The return on assets and equity from capital gains for dairy farms is very steady and generally increases each year. The capital gain for grain and hog farms is much more volatile and can fluctuate widely.

Figure 15: Return on equity from gain on land and buildings – grain farms

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Return to equity – Land and buildings

Figure 16: Return on equity from gain on quota, land and buildings – dairy farms

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Return to equity –Land, buildings and quota


Figure 17: Return on equity from gain on land and buildings – hog farms

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Total returns – The problem with any capital gain or recapture is that it does not arise until the assets are sold sometime in the future. In order to measure the value of the capital gain and the recapture in current dollars we calculated the present value of these amounts. To do this we require two additional pieces of information - the discount rate to be used and the discount period. In the case of the discount rate, there are a number of interest rates which we could use. However, for the purpose of this paper we have used the internal rate of return as calculated earlier in this paper when we calculated a current rate of return on assets and a current rate of return on equity for a ten-year period from 1992 to 2001. Current return on assets Current return on equity Grain farms 4.9% 6.0% Dairy farms 5.3% 6.2% Hog farms 4.8% 4.3% For the discount period we have assumed that everyone would retire at age 65. Using the average age of the oldest operator from the FFS and assuming a retirement age of 65 we constructed a discount period as shown in Table 1.


Table 1: Discount period Year Average age Years to retire

Grain Dairy Hogs Grain Dairy Hogs

1991 51.3 50.0 47.8 13.7 15.0 17.2 1992 51.4 49.5 47.0 13.6 15.5 18.1 1993 51.5 49.0 46.1 13.5 16.0 18.9 1994 51.6 49.1 45.9 13.4 15.9 19.2 1995 51.8 49.3 45.6 13.2 15.7 19.4 1996 51.3 48.3 45.6 13.7 16.7 19.4 1997 50.8 47.4 45.6 14.2 17.6 19.4 1998 51.6 47.8 47.1 13.4 17.2 17.9 1999 52.3 48.3 48.6 12.7 16.7 16.4 2000 52.6 49.6 48.2 12.4 15.4 16.8 2001 52.8 50.5 47.8 12.2 14.5 17.2 Total return on assets – After calculating the present value of the capital gains and adding it to the current rate of return on assets, the average return on assets changed (Figures 18, 19 and 20): - increased from 4.9% to 6.1% for grain farms - increased from 5.3% to 9.6% for dairy farms - decreased from 4.8% to 4.7% for hog farms. In the case of the hog farms the capital gains in present value terms was zero (-0.1% over the ten-year period).

Figure 18: Total return on assets – grain farms

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Figure 19: Total return on assets – dairy farms

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Ye a r

Total return to assets




Total return on equity – The average return on equity for grain farms increased from 6.0% (excluding capital gains) to 8.2% after including the capital gains (Figure 21). In the case of dairy farms the effect was even more significant (Figure 22), increasing the rate of return on equity from 6.2% (excluding capital gains) to an average of 17.8% per year. In the case of dairy the returns to equity are greater from the capital gains (11.6%) than the current returns from farming at 6.2%. In the case of hog farms, the return on equity for hog farms decreased from 4.3% (excluding capital gains) to 3.9% after including the capital gains (Figure 23). This is not surprising because most modern hog farms have no significant land base and their buildings lose their value over time thus eliminating any capital gains.

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent



Figure 20: Total return on assets – hog farms

Figure 21: Total return on equity – grain farms

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Figure 22: Total return on equity – dairy farms

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Year

Percent

Total return to equity

Current return to equity



-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent



Figure 23: Total return on equity – hog farms

Is the market efficient? In Ontario and Quebec grain farms can grow corn and soybeans which produce a much higher return per acre compared to wheat. In the Prairie Provinces corn and soybeans are not an option and thus, the primary crops are canola and wheat. The results are that the cost of an acre of farmland is much higher in Ontario and Quebec compared to the Prairies as shown in table 2. The price per acre averaged $2,126 in Ontario and Quebec between 1992 and 2002 compared to $436 per acre in the Prairies over the same period.

Table 2: Average value per acre – land and buildings

Year Quebec and Ontario Prairie Provinces $ 1992 1,708 326 1993 1,700 329 1994 1,717 354 1995 1,785 395 1996 1,942 423 1997 2,148 452 1998 2,275 474 1999 2,383 488 2000 2,462 505 2001 2,577 520 2002 2,683 531 Average 2,126 436

Source: Statistics Canada, Value of Farm Capital – Agriculture Economic Statistics, catalogue no. 21-013-XIE. The higher price associated with farmland in Ontario and Quebec is partially due to the higher returns per acre from corn and soybeans compared to the return per acre in the Prairies associated with the production of wheat and canola. We would expect that if the market is efficient that the return on assets for Ontario and Quebec farmland should be approximate equal. In Figure 24 the current return on assets is shown for Prairie grain farms and grain farms in Ontario and Quebec. The return on assets is higher for Prairie grain farms averaging 5.3% per year over the eleven-year period. This compares to a slightly lower rate of return of 4.9% for Ontario and Quebec grain farms which would suggest that the price of farmland in Ontario and Quebec in terms of grain production is too high.

Figure 24: Return on assets – East\West grain farms

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Percent

In a similar manner the return on equity (Figure 25) for Prairie grain farms is higher than the return on equity for Ontario and Quebec grain farms. During the period 1992 to 2002 the return on equity averaged 6.9% in the Prairies compared to 6.1% in Ontario and Quebec.

Figure 25: Return on equity – East\West grain farms

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

Percent

Return to assets – Prairie grain

Return to assets – Ontario & Quebec grain

Return to equity – Prairie grain

Return to equity – Ontario & Quebec grain

However, this is current return before any capital gains is taken into account. In Figure 26, the return on assets from the capital gains on the land and buildings in present value is much higher in Ontario and Quebec, averaging 4.2% for the ten-year period from 1992 to 2001. This compares to only a very small return from capital gains of 0.5% in the Prairies. Part of the problems in the Prairies is that when grain prices are higher (1995) the capital gains on farmland and buildings are high but, then it goes negative when grain prices drop. In Ontario and Quebec, the capital gains are much more consistent from year to year probably due to a strong urban influence. In Figure 27, the return on equity from the capital gains on the land and buildings in present value is again much higher in Ontario and Quebec, averaging 7.1% for the ten-year period from 1992 to 2001 compared to only a 0.9% return on equity in the Prairies. In Figure 28 we add the current return on assets from farming to the return on assets from the capital gains on the land and buildings to get a total return for the ten-year period from 1992 to 2001. Once the return on assets from capital gains included, the total return on assets is much higher for Ontario and Quebec grain farms, averaging 9.0% return over the ten-year period from 1992 to 2001. This compares to a 5.9% total return on assets for Prairie grain farms during the same period. In a similar manner the total return on equity is much higher for Ontario and Quebec grain farms (Figure 29) compared to Prairie grain farms. Over the ten-year period the return on equity averaged 12.8% in Ontario and Quebec compared to 8.1% in the Prairies.

Figure 26: Capital gains on assets – East\West grain farms

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Figure 27: Capital gains on equity – East\West grain farms

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Return to assets –Land and buildings – Ontario & Quebec grain

Return to assets – Land and buildings – Prairie grain

Return to equity – Land and buildings – Ontario & Quebec grain

Return to equity – Land and buildings – Prairie grain

Figure 28: Total return on assets – East\West grain farms

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Figure 29: Total return on equity – East\West grain farms

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Percent

Total return to assets – Ontario & Quebec grain

Total return to assets - Prairie grain

Total return to equity – Ontario & Quebec grain

Total return to equity – Prairie grain

Levels of risk in farming compared with those of other industries The rate of return is only one factor to consider. The other factor that must be considered with any investment is the level of risk associated with these returns. The acceptable level of risk to an investor varies from one individual to another. The higher the level of risk associated with an investment, the higher the rate of return that an investor will require in order to be compensated for the higher level of risk. Conversely the same investor would be ready to accept a lower rate of return if the level of risk is lower. Thus, the rates of return in tables 3 and 4 are only relevant if one measures the level of risk associated with the rates of return for each sector. To measure the level of risk we calculated the variance of the rates of return on assets over the time period. The results are shown in tables 5 and 6. Dairy farms show the lowest level of risk with a variance of 0.005%. The food manufacturing sector and grain and oilseeds have similar levels of risk at 0.015% and 0.018% respectively. Most sectors show a variance of between 0.065% and 0.075%. The highest levels of risk were in the wood paper manufacturing and the oil and gas extraction industry with variances of 0.230% and 0.171%. This shows that farming has a lower level of risk than another natural resource based industry. This is not surprising because the other sectors do not have safety net programs available to them to reduce the risk. Mining, on the other hand, has a very low risk, but also a low rate of return on assets. When we include the capital gains in the rate of return for grain and oilseed farms the variance increases from 0.015% to 0.034%. In the case of dairy farms the level of risk increases even further with the variance increasing from 0.005% to 0.063%. However, except for the food manufacturing and mining sectors the level of risk is still below most other sectors.

Table 3: Current return on assets (%)

Year Grain Dairy Hog Food Oil and Wood and Primary Mining farms farms farms manuf. gas extrac. paper man. metal man. 1992 4.2 6.4 7.2 5.5 4.6 -1.0 -0.3 0.8 1993 4.8 5.5 5.7 5.6 7.0 2.3 1.9 0.0 1994 4.5 5.3 4.3 5.9 7.0 7.9 4.9 2.0 1995 5.9 5.2 4.4 5.8 7.5 16.9 8.8 3.4 1996 7.4 4.5 4.5 5.9 12.0 6.2 6.5 2.3 1997 5.2 3.8 5.5 5.8 8.6 3.4 6.8 2.5 1998 4.5 5.3 0.8 5.9 2.6 5.2 5.6 1.5 1999 3.0 5.6 -0.1 8.9 4.3 8.1 7.5 1.3 2000 3.7 5.8 6.8 8.4 15.6 9.5 5.9 2.8 2001 5.6 5.6 8.5 8.2 12.9 6.1 1.3 1.9 Aver. 4.9 5.3 4.8 6.6 8.2 6.5 4.9 1.9

Table 4: Total return on assets (%)

Year Grain Dairy Hog Food Oil and Wood and Primary Mining farms farms farms manuf. gas extrac. paper man. metal man. 1992 3.9 7.2 7.2 5.5 4.6 -1.0 -0.3 0.8 1993 3.2 6.1 9.6 5.6 7.0 2.3 1.9 0.0 1994 6.5 7.7 2.2 5.9 7.0 7.9 4.9 2.0 1995 8.6 8.4 0.1 5.8 7.5 16.9 8.8 3.4 1996 6.6 9.9 3.5 5.9 12.0 6.2 6.5 2.3 1997 4.9 7.6 5.5 5.8 8.6 3.4 6.8 2.5 1998 7.9 11.9 3.6 5.9 2.6 5.2 5.6 1.5 1999 6.3 11.4 2.3 8.9 4.3 8.1 7.5 1.3 2000 4.9 13.1 5.7 8.4 15.6 9.5 5.9 2.8 2001 8.2 12.6 6.7 8.2 12.9 6.1 1.3 1.9 Aver. 6.1 9.6 4.7 6.6 8.2 6.5 4.9 1.9

Table 5: Level of risk – Current return on assets (%)

Stat Grain Dairy Hog Food Oil and Wood and Primary Mining farms farms farms manuf. gas extrac. paper man. metal man. Average 4.9 5.3 4.8 6.6 8.2 6.5 4.9 1.9 Minimum 3.0 3.8 -0.1 5.5 2.6 -1.0 -0.3 0.0 Maximum 7.4 6.4 8.5 8.9 15.6 16.9 8.8 3.4 Variance 0.015 0.005 0.072 0.018 0.171 0.230 0.087 0.010

Table 6: Level of risk – Total return on assets (%)

Stat Grain Dairy Hog Food Oil and Wood and Primary Mining farms farms farms manuf. gas extrac. paper man. metal man. Average 6.1 9.6 4.6 6.6 8.2 6.5 4.9 1.9 Minimum 3.2 6.1 0.1 5.5 2.6 -1.0 -0.3 0.0 Maximum 8.6 13.1 9.6 8.9 15.6 16.9 8.8 3.4 Variance 0.034 0.063 0.080 0.018 0.171 0.230 0.087 0.010 Source: Statistics Canada, taxation data, Farm Financial Survey and CANSIM

Conclusions The results of this analysis show that the current return on assets over the ten-year period from 1992 to 2001 was highest for dairy farms at 5.3%. Grain and oilseed farms and hog farms were slightly lower and very close at 4.9% and 4.8% respectively. The level of risk for hog farms, as measured by the variance, is much higher at 0.072% compared to 0.005% for dairy farms. Even grain farms at 0.015% have more than three times the level of risk compared to dairy farms. The highest levels of risk were in the wood and paper manufacturing and the oil and gas extraction industries with variances of 0.230% and 0.171%. This shows that farming has a lower level of risk than some natural resource-based industries. Mining, on the other hand, has a very low risk, but also a low rate of return on assets. Once you include the capital gain on land and buildings and in the case of dairy farms on quota the rate of return increases significantly to 6.1% for grain farms and 9.6% for dairy farms. However, at the same time the risk associated with these returns doubled for grain farms increasing from 0.015% to 0.034% and increased substantially from 0.005% to 0.063% for dairy farms. Hog farms on the other hand actually saw the return on assets decrease from 4.8% to 4.6% while the level of risk increased from 0.072% to 0.080%. The average current return on assets for farming over the ten-year period 1992 to 2001, at 5.0%, is lower than other sectors such as food manufacturing at 6.6%, oil and gas extraction, at 8.2%, and wood and paper manufacturing, at 6.5%. However, at the same time the level of risk for grain and oilseeds and dairy farms is much less than the level of risk in the oil and gas sector (0.171%) and substantially less than the level of risk in wood and paper sector where the return on assets ranged from a low of –1.0% to a high of 16.9% with a variance of 0.230%. Interesting enough, one of the lowest levels of risk is in the food manufacturing sector with a variance of 0.018%. Once we include the capital gain on land and buildings and quota the rate of return is very comparable with other sectors and at a lower level of risk. The main reason for the lower level of risk for grain and oilseeds farm is due to the effect of government programs. In the absence of government programs the variance for grain and oilseed farms would be 0.060% however, the variance on program payments is lower at 0.044% thus reducing overall level of risk. At the same time programs payments have increased the average return on assets from 1.0% with no program payments to 5.0% after including program payments. On the question of is the market efficient the total return on assets would suggest that the price of farmland in Ontario and Quebec in terms of grain production is too low or conversely the price in the Prairies is too high. This contradicts our previous observation which we made when we looked solely at the current return where the current return was lower in Ontario and Quebec. There is an explanation for this apparent contradiction. Although a farmer could pay a higher price based on the total return almost half of this return is in the form of capital gains which is not available to service the debt. Thus, the price which can be paid is limited by the ability to service the debt from the current return. In view of the fact that the current return in Ontario and

Quebec is lower than the current return in the Prairies it would suggest that this is the biggest constraint in determining the price to be paid for the farmland.

Table 7: Average total return on assets, 1992 to 2001 – grain farms

Region Current return Capital gains Total return Prairies 5.4% 0.5% 5.9% Ontario and Quebec 4.7% 4.4% 9.1% Canada 4.9% 1.2% 6.1%

Bibliography Burroughs, R., D. Harper, D. Smith, and M. Trant. 2001. Businesses in the food chain survive the turmoil of the 1990s. In VISTA on the Agri-Food Industry and the Farm Community. Cat. No. 21-004-XPB, 1-6. Burroughs, R. and D. Harper. 2002. An analysis of profits in the Canadian food processing sector. Statistics Canada. Agriculture and Rural Working Paper Series. Working Paper No. 59. Deloitte and Touche. 2002. Benchmarking for Success 2002. http://www.deloitte.com/dtt/cda/doc/content/Benchmark2002ENG.pdf. Farm Credit Corporation. 1991. Farm Accounting Standardization Review Committee: Farm accounting standardization manual. Financial guidelines for agricultural producers: Recommendations of the Farm Financial Standards Council. December 1997. Morehart, M., E. Nielsen and J. Johnson. 1988. Development and Use of Financial Ratios for the Evaluation of Farm Businesses. United States Department of Agriculture, Economic Research Service. Technical Bulletin Number 1753. Smith, D. and M. Trant. 2002. Performance in the food retailing sector of the agri-food chain. Statistics Canada. Agriculture and Rural Working Paper Series. Working Paper No. 056. Statistics Canada. 2005. Agriculture economic statistics (Statistics Canada Catalogue no. 21-010 to 21-018). Vogel, F. and J. Johnson. 2000. Measuring agricultural income with the changing face of agriculture. Paper presented at the 7th IWG-AGRI Agricultural Economics Statistics Seminar. Luxemburg July 5-7, 2000.

Documents

Profitability in Farming: Rates of Return and Comparison