Return on equity is the farm manager’s big picture ratio
When it comes to farm financial management, there’s no shortage of ratios and indicators to look at, whether it be debt servicing, working capital or gross margin.
However, there’s one that sometimes gets overlooked, even though it sits right at the top of the list when looking at the big picture: return on equity (ROE).
ROE tells you what kind of return your farm business is generating on your investment, your equity. It is calculated by dividing the net income number from the income statement by the equity value from the balance sheet.
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Think of equity as what you’d walk away with if you sold everything, paid off all your liabilities and pocketed the remaining amount. That’s your investment in the business.
Every year that you stay farming, you’re essentially reinvesting that equity. So, it makes sense to occasionally step back and ask, what kind of return am I getting on my investment?
ROE is one of those “big picture” ratios that gives a bird’s-eye view of the farm’s overall performance.
It’s worth reviewing every year, and is even more valuable when you look at the trend line over three to five years. Is the business consistently generating a return to the owners? Is that return improving, declining or holding steady?
If your ROE is trending upward, great. But if it’s declining or erratic, it might be a sign to dig deeper into what’s causing that.
As farm managers and owners, it’s important to understand what’s driving the change in your equity position. Is your equity increasing because your operations are profitable and you’re retaining earnings, or is it mostly due to land appreciating over time?
To make sense of that, you first need to know what kind of land values you’re using in your balance sheet, cost basis or market values. This matters because the choice affects the ROE result.
If you use market values, your land is worth more on paper as prices rise, which increases total equity. That sounds great, but it also makes your ROE look smaller since you’re dividing by a larger equity number.
On the other hand, using cost basis values (the price you actually paid for the land) makes the equity smaller, which increases your ROE, showing a stronger return from operations.
Neither approach is wrong. In fact, it’s helpful to look at both.
Using cost values gives a clearer picture of the earned return from operations, while using market values helps you see the equity growth from being a landowner. Together, they tell a more complete story about your farm’s performance.
ROE can also be a bit tricky.
A farm that’s highly leveraged (carrying a lot of debt) might show a higher ROE than a similar farm with lower debt. Why? Because the leveraged farm has less equity. If both farms earn the same income, the one with less equity will have a higher ROE.
Sounds good, right? Well yes, but that higher ROE comes with higher financial risk.
The same leverage that boosts your return in good years can amplify losses when things don’t go as well. Conversely, a farm with low debt and a strong equity position might show a more modest ROE, but it’s also more stable and less exposed to financial swings.
That’s why ROE should never be looked at in isolation. It’s one piece of the puzzle. You can use it with ratios such as debt-to-equity and net operating profit margin to get a balanced view of how your business is performing and how much risk it’s carrying.
At the end of the day, return on equity is one of the most important indicators in farm business management. It helps you see whether your business is generating a worthwhile return on your investment and indicates whether that growth is coming from operations, land appreciation or a combination of both.
ROE doesn’t tell you everything, but it helps you ask the right questions for the big picture look at the farm. Are you happy with the return you’re earning on your equity? Are you taking on more risk than necessary to achieve it? Does it align with your long-term goals?
If financial ratios make your head spin, just remember, reviewing ROE once a year is like getting a checkup from your doctor. It doesn’t take long, but it can prevent a lot of trouble down the road.
Gavin Betker is a farm management consultant with Backswath Management Inc. He can be reached at 204-995-4978 or gavin.betker@backswath.com.
Source: producer.com