Good farm returns allow debt repayment, better jobs, investment in productivity and the environment, and allow for farm succession, Anne Hardie reports.
Dairy farmers have relied heavily on capital gain in the past as land values climbed, but an agribusiness specialist says it’s high time the industry started talking about the return on the assets used to generate income from milk production.
David Densley is the consultant manager for Headlands and is also the Dairy Business of the Year (DBOY) manager which includes an analysis of return on capital (ROC) in the awards’ statistics.
Last year the finalists had businesses that realised a ROC between 4.3% and 7.9%, while Densley says too many farm businesses would have no idea about their own ROC.
The measure for return on assets (ROA) or ROC is calculated by dividing the earnings of the business before interest and tax (EBIT) by the market value of the assets – land, stock plant and dairy company shares – used to earn the income, after allowance is made for a wage to the farm owner.
Densley says the ROA or ROC measure enables a comparison of the returns of one farm with another, or alternative off-farm investments. It requires an understanding of the current and probable future ROC based on expectations for product prices, farm production and income.
“When you understand the farm ROC and can compare it with other dairy operations, you are better placed to define how your farm performs as an investment now and, once that comparison is made, how you can improve business performance.
“To be a good investment, the farm capital should earn a better return than investments of similar risk. Good returns allow debt repayment, better jobs, investment in productivity and the environment, and allow for farm succession.”
Over the years, farmers have expected land value gain as part of the returns of owning a farm, he says, but expectations are now reduced due to low inflation, scope for farm productivity gain and volatile product prices. Farm values are linked to earnings, and increases in value based on earnings increase, and the expectation for this has reduced.
However, he says evidence shows the best performing New Zealand farms across all farm systems do achieve a good ROC.
“We should be talking about ROC and the industry hasn’t been doing that in the past. Now we’re in a phase where land prices are not going up any longer – they’ve settled out. We can’t rely on that capital growth to get equity in our business; we have to get equity from the performance of that business. And that’s how it should be done.”
ROC, he explains, is the yield from the money invested in the business, while operating profit margin – the other important figure for a business – is a resilience measure which shows how much money is left each year to pay principle, taxes, etc.
They are the two most important financial metrics in a dairy business, yet seldom known, he says. But they give the best information about a farm’s performance and can be compared with other farms anywhere in the country.
And those figures can be surprising, showing farm businesses in regions such as the West Coast and Northland which are often overlooked by buyers, are capable of competing with the more recognised, high-production regions.
Last year, two West Coast dairy farms were finalists in the DBOY awards including Pan Farms which achieved a ROC of 6.5% on its 2016-17 figures and operating profit margin of 30.2%, while Clear Creek had a ROC of 4.9% and operating profit margin of 30.4%. Those figures compared well with finalists from other regions and despite a considerably lower payout that season from Westland Milk Products.
“The productivity capacity of the West Coast for those top operators is good compared with the capital they have tied up in their business. They’re not paying over-inflated prices for the land compared with their productivity capacity. And the cost of production per unit of milk produced is under control.”
It was the second year in a row that Pan Farms had been named a finalist in the awards which Densley says is a true measure of resilience.
In the 2017 awards which used the 2015-16 season figures, a Northland farm business proved what can be achieved by being named runner up despite operating a system 5 in a year when most of the industry lost money.
While West Coast and Northland have cheaper land, Densley says there’s no point buying a cheap farm if the earnings opportunity isn’t there.
“You don’t want to pay over-capitalised prices for the land. And your production costs need to be in line with the top 5-10% of farms in the country.
“The problem is the industry has not been talking about ROC in the past and it needs to because it’s all about how much cash they’ve got tied up in the business. If I take that investment somewhere else, what sort of yield can I get for that cash?”
The ROC for too many dairy businesses is not great compared with alternatives for that capital, which shows the need for budgets, cashflows, benchmarking and a desire to improve financial performance, he says.
“If you have a $2.5 or $10 million business, you need to be doing those things. We want and need a dairy industry that is resilient during years of milk price fluctuations in order to have a robust dairy industry moving forwards. Those farms need to be achieving a return from those assets and they need to be making a margin to pay debt. and it starts with defining your current ROC.”