Terry Betker, P.Ag., Cac, Cmc, Backswath Management Inc., Dr. Larry Martin, Ph.D.

25 BENCHMARKING FINANCIAL AND MANAGERIAL PERFORMANCE Terry Betker, P.Ag., Cac, Cmc, Backswath Management Inc., Dr. Larry Martin, Ph.D. Agri-Food Management Excellence Abstract Top producers use benchmarking to compare the performance of their farm operation against that of their peers. Benchmarking assists them to identify strengths and weaknesses of their operation as well as areas in need of improvement. Historically benchmarking has been used to compare yields, e.g. piglets/sow, return per bird, production per cow, etc. Today s top farmers are taking benchmarking to a much more sophisticated level. Some are comparing to global performance and most are eager to compare to industry benchmarks both from a managerial and a financial comparison perspective. Leading farmers are finding that benchmarking makes the business of farming more rewarding. The farm operation is looked at as not being just a profit centre or a lifestyle but as an innovative and dynamic entity where they can compete against themselves, their past performance and where they also compare and compete with others locally, nationally and internationally. Farmers are interested in the correlations between management and financial performance to better understand which best practices are used in what ways in order to replicate similar achievement. In other words, to determine what leading farmers actually do to consistently achieve superior financial performance. Keywords: benchmarking, financial management, farm management, ratios 1. Introduction Top producers understand their farm business. They know their financial and production profiles. And they use benchmarking to compare the performance of their farm operation against that of their peers. Benchmarking assists them to identify strengths and weaknesses of their operation, and areas in need of improvement. It allows them to set future goals and improve their production levels. Historically benchmarking has been used to compare yields, e.g. piglets/sow, return per bird, production per cow, etc. Today s top farmers are taking benchmarking to a more sophisticated level. Some are comparing to global performance and most are eager to compare to industry benchmarks both from a managerial and a financial comparison perspective. Communication technology has improved the ability of farmers to access information. Leading farmers are finding benchmarking makes the business of farming more rewarding. The farm operation is looked at as not being just a profit center or a lifestyle, but as an innovative and dynamic entity where they can compete against themselves, their past performance, and where they compare and compete with others locally, nationally, and internationally. Farmers are interested in correlations between management and financial performance to better understand which best practices are used in what ways in order to replicate similar achievement. In other words, to determine what leading farmers actually do to consistently achieve superior financial performance. July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 1 of 10

26 TERRY BETKER, DR. LARRY MARTIN 2. Financial Performance Successful farm operators know the importance of continuously evaluating their business performance. But to truly complete a thorough examination of an operation's effectiveness, a farmer needs to look at more than just numbers like sales, profits, and total assets. Leading farm managers must be able to read between the lines of financial statements and make the necessary correlations that shed light on the seemingly inconsequential numbers and render them more accessible, comprehensible, and ultimately more usable. Fortunately there are well-tested ratios that make the task less daunting. While ratios are useful tools to analyze business performance, they come with some pros and cons. Good news is, ratios can be quantified with a high degree of confidence. They can be compared year over year to measure progress, being most meaningful when comparing the current year s financial measures with the same measures from earlier years. The bad news is a ratio is only as good as the information used to prepare it. Since each ratio reveals a little about the farm s financial story, it is important that they be analyzed collectively because some ratios can be counterintuitive. Following are some key ratios that can be used effectively to measure and benchmark financial performance. 3. EBITDA A measure of operating profitability, EBITDA is an acronym for Earnings before Interest, Taxes, Depreciation and Amortization. EBITDA is calculated by first subtracting production expenses, operating expenses and overhead and administration expenses from gross revenue. From this total, add back interest and amortization (or depreciation as it is sometimes referred to) to arrive at EBITDA. Interest includes interest on long-term loans as well as operating loans. An approach is to take overall net income and add back interest and amortization or depreciation. The reference to taxes in the calculation is for income taxes and NOT property taxes. EBITDA is sometimes referred to as operating earnings. EBITDA represents the profit generated by the business before factoring in how the business is capitalized and financed. It is used effectively to compare the financial performance of different businesses or different enterprises on an apples to apples basis because it looks at the operating efficiency of the entities without thinking about how much capital investment is required or how much financing exists. It can be used to compare two farms financial performance even though one farm may have little debt and a moderate to small investment in capital while the other may be highly leveraged and using a full line of new equipment. Further, one farm could own a lot of the land being farmed, and therefore have a higher capital investment while the other farm could own little land and have more rented land. Below is a representation of a farm income statement. Expenses are organized into six categories. Subtracting direct production related expenses (fertilizer, chemical, seed, feed, veterinary, feeders) from gross revenue gives gross margin. Then subtracting operating costs such as labor, machinery operating and other variable expenses gives a contribution margin. Subtracting the farm s overhead expenses results in EBITDA. Gross Operating Revenue (-) Crop and Livestock Expenses (=) Gross Margin (-) Labor, Machine and other Operating Expenses (=) Contribution Margin (-) Management, Office and Overhead Expenses (=) EBITDA (-) Depreciation/Amortization (-) Interest July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 2 of 10

BENCHMARKING FINANCIAL AND MANAGERIAL PERFORMANCE 27 (=) Earnings Before Taxes (-) Taxes (=) Earnings After Taxes (+/-) Non-Core Income and Expenses (=) Net Income Notice that all of the expenses deducted to get to EBITDA are operating expenses. They do not directly include the cost of capital and financing. Non-core income and expenses captures transactions not related to the core farm operation. This would include government payments, gains or losses from capital expenditures, custom work if it is not considered to be core, and incidental revenue such as patronage dividends. 4. Operating Efficiency The operating efficiency ratio is calculated by dividing EBITDA by gross operating revenue. It is a measure of how efficient the operation is at generating a margin before including expenses associated with how the business is capitalized and financed. The operating efficiency ratio can be used to effectively compare the financial performance of different businesses, where the businesses may have significant capital and financing requirements. Data from both Canada and the US show that for most crop and livestock farms, the ratio should be 35 per cent or higher (usually averaged over a number of years). In other words, after paying all operating expenses, for every dollar of gross operating revenue generated, the farm should have $0.35 left. Work done several years ago by Al Mussel (George Morris Centre 2012) showed that there is significant variation in this measure among Canadian farm tax filers. However, the ranges are not much different whether they are beef, hog, cash grain, dairy farms, or whether they are large or small operations. This suggests the operating efficiency metric has application across multiple sectors within the production sector. This further substantiates the application of the operating efficiency metric within a benchmarking activity. 5. Using Operating Efficiency to Diagnose Operating Problems If operating efficiency is less than 35 per cent, it is important to determine the reason so corrective action can be taken. What is causing the operating efficiency to be lower and what needs to be done to fix it? This gives rise to a powerful application of the standardized operating statement and its attendant benchmark ratios. To point, what are the farmers doing managerially that gives them results at, or above, the 35 per cent benchmark? If one looks above the EBITDA line, it is apparent three sets of costs are deducted from revenue to arrive at this indicator: crop and livestock expenses; labor, machine operating, management, office and general overhead expenses. There are general industry benchmarks for each category: crop and livestock expenses should be no more than 35 per cent of gross operating revenue; labor and machine operating should be 15 to 20 per cent; management, office and overhead expenses should be no more than 10 to 15 per cent. By definition, this means Gross Margin should be 65 per cent or more of sales and Contribution Margin should be 45 to 50 per cent of sales. Assume that a farm has Operating Efficiency of 22 per cent, which is the longer term Canadian average. What is keeping it from achieving 35 per cent? Why is it not generating a higher profit? One way to diagnose this is to look at the other ratios. Assume the farm s Gross Margin ratio is 57 per cent and its Contribution Margin is 45 per cent. What information does this provide? July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 3 of 10

28 TERRY BETKER, DR. LARRY MARTIN First, because the difference between Gross Margin and Contribution Margin is only 12 per cent, this farm is doing a great job of managing operating costs in terms of labor and other operating costs 15 to 20 per cent is the standard this farm is beating it. However, there is an issue with its Gross Margin. Its production expenses are 43 per cent of total revenue and the industry benchmark says they should be 35 per cent or less. The manager s focus should to be on production efficiency and/or marketing. The farm is not getting enough for what it is selling, its conversion of inputs into products is underperforming and/or it is paying too much for inputs. Following back to the detail will help to pinpoint the exact problem. Another farm with 22 per cent Operating Efficiency has 70 per cent Gross Margin and 33 per cent Contribution Margin. This farm has different problems. Crop and livestock costs are 30 per cent of revenue, better than the standard. But its operating costs are 37 per cent, far worse than the standard 15 to 20 per cent. The immediate focus for this operation will be on some combination of labor and machinery costs and other operating costs. Often, when this category is this far off-base, it may be that the farm is expensing equipment and machinery to increase expenses for tax purposes when the proper treatment for management purposes would be amortize the costs associated with the investment over time (depreciation). This financial information and the associated industry benchmarks prove to be very powerful tools in helping farm managers manage well, and to undertake realistic strategic and operating plans. While it is useful and important to evaluate financial performance each year, there is significant value in understanding the trends and comparisons over a period of years. Seeing the trends can identify successes or problems over time. Comparison to the benchmarks over time provides yet further insight into financial performance strengths and weaknesses. 6. Debt / EBITDA Debt/EBITDA is really debt to operating earnings because EBITDA is operating earnings. It is calculated by dividing debt by EBITDA. Assume Debt/EBITDA is 5.0. It means that if all operating earnings were used only to pay principal on existing debt, it will take five years to pay the debt off assuming the EBITDA represents operating earnings for a year period. During that time none of the annual operating earnings will be used to pay interest, to make new investment, to pay income taxes or to provide a return to ownership. 7. Using Debt / EBITDA As noted, successful farms aim for operating efficiency of 35 per cent or more. If a farm has 22 per cent operating efficiency and debt/ebitda of 8:1, it is going to be very difficult for it to pay off its debt. It will be increasingly difficult to make any major new investment. The ratios reveal two things that need management attention. One is to reduce debt as quickly as possible and, certainly, not take on more debt. The other is to improve operating efficiency from 22 percent so debt can be paid down more quickly. Another useful aspect of this ratio is it can help guide growth plans. Some of the most successful operations have Debt/EBITDA at 2.5:1 to 3.0:1 on average over time. However, it may jump up to 5:1, 6:1 or even higher when a new major investment is made such as a farm expansion. But it goes down to less than 2.5:1, as that debt is paid off and before the next investment is made. 8. Balanced Management The major management functions on a farm can be categorized into four key areas; marketing, operations, human resources, and finance. Marketing includes a farmer s suppliers and consumers. Operations are the work that is being done (i.e. seeding and harvesting). Finance deals with financial performance, and human resources attends to ownership, management and labor components. Businesses, July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 4 of 10

BENCHMARKING FINANCIAL AND MANAGERIAL PERFORMANCE 29 including farms, and especially those with a growth orientation or those working within an intergenerational transfer, must work to achieve and sustain a relative balance, or harmony, within and between the management functions. Success on the farm is a function of many elements and while there is no one right way to manage a farm, farmers have traditionally treated the management functions independently. Events that impact the farm management functions can result in those functions coming out of balance, creating uncertainty, risk and generally poorer performance as the farm moves forward. Long-term sustainability is enhanced by a farmer s ability to keep the management functions in balance or as close to balance as possible. The concept of a balanced management approach is entrenched in Balanced Scorecarding. Balanced Scorecarding was developed in the early 1990 s by Kaplan and Norton. Both internal and external events can result in the functions going out of balance. External events such as a change in trade policy or global supply and demand relationships can be very challenging but nonetheless must be managed. Internal events such as increasing the productive asset base can at times be just as challenging but are typically within a farmer s control. Management decisions made by a farmer can result in scenarios where management functions come out of balance ; usually with related and undesirable outcomes. For example, operations-based decisions and their impact on marketing and finance. Intuitively, farmers understand the importance of keeping the different management functions in balance but prefer to focus their efforts on operations because, quite simply, that is what they like to do. Farmers have only one absolute constraining resource their time. The management functions of a farm need to advance and change as the business grows or transitions. Coupled with the demand for more time comes the requirement for advanced management skill sets that extend well beyond those that are traditionally applied. In addition to understanding the importance of managing the human resources of a farm in general, farmers must, most importantly, effectively manage their own human resource. Many successful farmers recognize and accept this. They look to external resources to help keep the management focus where it should be, helping to keep the management functions in balance. 9. Benchmarking Performance Benchmarking performance against the achievements of other producers is one of the resources leading farmers use to guide their decision-making. Benchmarking can be applied in four different ways. Farmers can benchmark against: 1. Their own performance by comparing current accomplishments to historical trendlines; 2. General industry standard performance guidelines; 3. A peer group or a number of farmers with a common interest in benchmarking their performance against each other; and 4. Their forecasted baseline performance as an indication of where a farmer s performance is tracking, given what has happened in the past. Two further questions need to be considered for the final point above. First, if the forecasted performance were to materialize, would it be acceptable, and second, if not acceptable, what can be done to improve it? Future-focused targets or performance goals can then be established and used to determine if their performance is getting them to where they want to, or need to be. Benchmarking can be used in each of the four main management areas identified above. It is used extensively in production yield and cost per productive unit and to a lesser degree, marketing units of production sold in the top quartile, for example. Benchmarking financial and managerial performance is less common. Farmers who participate in a financial benchmarking exercise and are able to see how their performance compares to others very quickly want to know what the farmers who report top quartile performance results are doing, or have done, to achieve the results. July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 5 of 10

30 TERRY BETKER, DR. LARRY MARTIN An assumption can be made that better managed farms are more profitable. The question that follows is how to measure whether this is true. In order to answer the question, there must be a way to compare the financial and managerial performance of farms. There are three key issues to consider: Finance o Financial analysis needs to be standardized. Accounting firms present financial statements for farms in several formats which makes benchmarking difficult. o Financial analysis must utilize accrual accounting. Cash-based financial statements do not provide an accurate enough base of information upon which to benchmark performance. o Financial statements must be based on original cost less depreciation or amortization. Market value adjustments impact financial performance and, because they are usually based on subjective opinion, result in less assurance in the quality of the benchmarks. o There is significant variability from farm to farm in how they are capitalized and financed, which in turn impacts on benchmark results. Management o Management analysis needs to be standardized as part of a benchmarking exercise. o Analyzing managerial performance is generally a qualitative exercise based on surveys and interviews that examine best management practices. o Comparing financial and managerial performance in a benchmarking exercise requires a quantitative-based framework. General o Most importantly, an approach needs to be developed that enables the comparison of financial and managerial results in a benchmarking exercise. A relatively small sample (n=18) study was conducted in 2014. (Agri-Food Management Excellence 2014) The study had two components financial and managerial performance. The following approach was used to overcome the challenges identified above. 1. A financial management software program was used to standardize financial information, ratios and indicators. 2. Accrual-based financial statements were used to establish the benchmarks. 3. The operating efficiency ratio was the metric used to provide indication of farm profitability. This ratio effectively provides a measure of a farm s financial performance without factoring in how it is capitalized or financed. This enables an apples to apples comparison of financial performance between farms. 4. A standardized management self-assessment was used to establish a management score so management practices could be compared from farm to farm. The self-assessment was based on a Balanced Scorecarding application. (Kaplan and Norton, 1992) 5. The management assessment was presented to farmers in an on-line survey. A spreadsheet underpinned the assessment. This resulted in the ability to apply a quantitative result to a qualitative assessment. 6. The operating efficiency ratio was the metric used to establish the linkage between financial and managerial performance to measure whether better managed farms are more profitable. The method used in the benchmarking exercise included the following key points. 1. Farmers submitted five years of historic financial statement information. 2. Information from the statements was transcribed into a standardized financial analysis database software program. July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 6 of 10

BENCHMARKING FINANCIAL AND MANAGERIAL PERFORMANCE 31 3. Farmers completed an on-line management self-assessment of their finance, marketing, operations and human resources management competencies. 4. Deliverables included: 1. Reports on individual farm performance: i. Graphical reports on key financial ratios and indicators. ii. Table format summary information on management performance by each of the management areas. 2. Benchmark information comparing individual farms to: i. Financial performance 1. Historical trendlines for individual farmers 2. Overall average group performance 3. Top quartile performance by each ratio and indicator 4. Top quartile performance by the operating efficiency ratio (as calculated by EBITDA divided by accrued Gross Operating Revenue). ii. Managerial performance 2.1.1. Best management practice summaries by: a. Performance for individual farmers b. Overall average group performance c. Top quartile performance with the top management quartile defined by the operating efficiency ratio. 10.1. Managerial Performance 10. Sample Reports The following chart is a partial sample of what farmers received in their Management performance benchmark report. There are 25 statements in each of the four management areas in the full assessment. FINANCE MANAGEMENT STATEMENTS Your Farm s Score Group Average Score Top 25% Group Score We know how much annual income we will require to have an adequate retirement standard of living. We have a financial plan in place that can support an intergenerational transfer and provide funds for all family members needs and wants. We sustain 65% gross margin efficiency (gross revenue minus fertilizer, chemical, seed, production insurance, feed, vet, and medicine/revenue). 3 4.7 4.9 4 4.8 5 2 3.7 4 FINANCE SECTION TOTAL (out of 10) 6.6 8.4 9.3 July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 7 of 10

32 TERRY BETKER, DR. LARRY MARTIN 10.2. Financial Performance The following charts are a partial sample of what farmers received in their financial performance benchmark report. There are 18 indicators and ratios in total, organized into liquidity, solvency, profitability and financial efficiency sections in the full assessment. July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 8 of 10

BENCHMARKING FINANCIAL AND MANAGERIAL PERFORMANCE 33 July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 9 of 10

34 TERRY BETKER, DR. LARRY MARTIN 11. Conclusion Profitability and long-term sustainability require that farm businesses develop and implement strategies designed to advance management practices. Combining a balanced approach to management with financial performance provides useful information when determining which business strategies to use and how outcomes are measured. Making management decisions that have substantial growth, or intergenerational transition, and related financial performance implications demand much more than looking at the business through an operational lens! While the number of participants in the study was too small to derive any statistically-based conclusions about the relationship between managerial and financial performance there were trends observed in the data. As farm-by-farm data was entered into the analytical programs, adjustments to the positioning of farms in the top quartile in each of financial and managerial performance metrics used appeared. This would suggest that factors differentiating managerial performance on more profitable farms would become better defined as sample size increased. Thus substantiating the argument that better managed farms are more profitable. 12. References Kaplan, Robert S. Conceptual Foundations of the Balanced Scorecard, 1992. Harvard Business School, Harvard University Mussell, Al & Martin, Larry. George Morris Center. Canadian Farms Becoming Larger with Greater Capital Investment, 2012 Betker, Terry. Backswath Management Inc. A Balanced Management Approach to Growing Farms, 2012 Betker, Terry. Backswath Management Inc. Farm Management Plans, 2014 Martin, Larry & Broughton, Heather. Agri-Food Management Excellence. Finance Metrics You May Not Have Thought Of Diagnosing Operating Inefficiency, 2015. Country Guide Betker, Terry. Backswath Management Inc. Farm Succession Planning A Workback Approach, 2012 Betker, Terry. Backswath Management Inc. Benchmarking Performance, 2015. Western Producer Farm Management Council. Managing the Multi-Generational Farm, 1997 July 2015 - ISBN 978-92-990062-4-5 - www.ifmaonline.org - Congress Proceedings Page 10 of 10