Dairy farm managers, given the financial stress of the last two years, are asking how to improve cash flow and reduce equity risk. Often the response is, “Perform a financial analysis.” Once the analysis is complete and results are in hand the question that typically follows is, “Where do I start with all of these numbers?” The follow up response is something like, “Compare your numbers to those of others, for example, AgFA benchmarks.”
Whether stated out loud or kept as a private thought the next user thought is “Huh??” and appropriately so! Now you have a boat load of numbers with foreign sounding titles and additional math formulas that are suppose to define them for you and, you’re told to go get more figures.
“This gives many managers and advisers a justification not to give their financial records anything more than a passing glance and that is unfortunate,” said Gregg Hadley, University of Wisconsin-River Falls and the Center for Dairy Profitability agricultural economist. “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 (future) financial performance.”
He added, “This denotes that a process or tool is indicated, a road map if you will to guide the user to their desired destination of improved financial performance.”
While we have tended to rely more on CPA type professional experience to guide us through the myriad of financial numbers, more and more tools are becoming available in support of the business manager. One of several such process tools is the DuPont Analysis.
“The DuPont system for financial analysis is a means to fairly quickly and easily assess where business strengths and weaknesses potentially lie and thus where management time may optimally be spent,” explains Kevin Bernhardt, agricultural economist of UW-Platteville and the Center for Dairy Profitability. “It is not the only or the most thorough, but it is a fairly straight-forward and systematic means to drill back into the financial numbers to determine the source or lack thereof for financial performance.”
According to Bernhardt, businesses earn profits by mixing their labor and management with inputs and capital assets to produce goods for sale. The DuPont system recognizes this recipe for profit making and segregates the financial appraisal into three distinct components or levers:
-- Earnings (or efficiency) – measured by how efficiently inputs are being used to generate profits,
-- Turnings (effective use of assets) – measured by how well capital assets are being used to generate gross revenues, and
-- Leverage (using debt to multiply earnings and equity) – measured by how well the business is leveraging its debt capital
The DuPont Analysis compares your business’s financial performance values of only three key measures to those of your peers:
-- Rate of Return on Assets (ROROA),
-- Asset Turnover Ratio (ATO) and
-- Operating Profit Margin (OPM).
It links a farm’s ROROA to two measures, ATO and OPM, by the following equation: ROROA = ATO times OPM.
Since the DuPont Analysis is asset-based, Hadley notes that 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 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 using a “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 asset value 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, such as better market planning, better milk quality, or better components.
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 individual cost 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 can investigate ways to reduce repair expenditures such 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 on farm financial performance and prioritize their farm activities accordingly.
An available spreadsheet, DuPont EasyCalc, http://cdp.wisc.edu/Dupont.htm calculates the above for you. Just input the values from your Balance Sheet, Income Statement and Financial analysis into the table in the “My Farm” column. Next, input the spreadsheet peer comparables from The AgFA database available from http://cdp.wisc.edu/AgFA.htm , (select “Benchmarks”) or those provided by your analysis service.
Alternatively, you may access the “Wisconsin Dairy Farm Benchmarking Tool” available at the above CDP DuPont website as well as at http://dairymgt.uwex.edu/tools.php#1. Simply input your financial measures and the tool not only makes the basic DuPont Analysis comparison with your values but also graphs where you stand in relation to your AgFA peers. Please be aware that while the above calculated ROROE values specific to your farm and those from your financial analysis report may be the same, average reported values from a database containing many farm businesses and those calculated with the above OTM times ATO formula may vary somewhat.
You may also use Bernhardt’s spreadsheet “DuPont Model Spreadsheet” for a three year comparison of your business performance and Hadley’s comparison template “A DuPont Analysis Report” located at http://cdp.wisc.edu/Dupont.htm to assimilate your financial analysis figures as compared to the average, low and high performing peers in the dairy industry.
Yes, trying to get our arms around many numbers can be a lot like herding cats or making sense of several thousand data points on a scatter graph. Once a process or strategy is defined, like moving those beloved felines into a blind corner or plotting trend lines on the scatter graph, success is much more evident.
This is the benefit of the DuPont analysis. It narrows down the many options to three main measures which can then be compared to the performance of other dairy producers. You may then select the measure most different from your peers and identify what production actions and other financial measures can direct you further towards financial success. Make your financial parameters work for you, perform a DuPont or similar analysis to make this otherwise elusive data come alive!!