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Audio Transcript:

00:06 – Role of a Chief Financial Officer (CFO)
James Mintert:
Thanks for joining us for a Purdue Commercial AgCast, the Purdue Center for Commercial Agriculture is podcast featuring farm management news and information. I’m your host today, Jim Mintert, director of the Purdue Center for Commercial Agriculture. And joining me today is Michael Langemeier, who’s a professor of ag economics and also the associate director of the Purdue Center for Commercial Agriculture.

Michael, we’re going to talk a little bit today about thinking like a CFO, a chief financial officer for your farm operation. And let’s start off by talking about the role of a chief financial officer. And maybe some folks are wondering what’s the difference between a CFO and an accountant, because they are not the same thing.

Michael Langemeier:
They are definitely not the same thing. An accountant, you might expect that they’re very transaction oriented, so they want to make sure that all your cash transactions, income and expenses, are entered into your record keeping system, whether that be QuickBooks or something like that. Also, accountants prepare reports, usually on historical information. They rarely look at reports looking at forecasting. That’s also very common for accountants. Also they maintain the general ledger meaning that they make sure the records are complete and accurate. One of the things that’s very important to keep in mind, accountants are always looking backward, what happened and really do not think about what might be happening in the next year or two.

James Mintert:
I think from a farm standpoint, most people think of an accountant in terms of preparing a tax return, which clearly is looking backwards. Right. With respect to what took place during a particular tax year and doing it in a way that’s accurate. That truly reflects what took place. But they’re not involved in making projections. Now, you can use the information they generate to help make projections, but that’s not their goal and not their role.

Michael Langemeier:
Yeah, that’s definitely the case. If you were thinking about making whole farm projections or enterprise projections using your latest historical cash, information is always a good place to start. So let’s contrast this to what we are calling the chief financial officer, and this is usually someone in the business. Now, obviously, if you’re the sole proprietor, you have a lot of different hats. But if you have a business that has let’s say we have four brothers farming together, or four brothers and sisters farming together, there’s probably one individual that’s responsible for keeping the records and analyzing those records and then sharing them with the rest of the family members. And so that person is a chief financial officer, and they’re analyzing the results.

So, they’re taking that cash information, they’re taking balance sheet information, and they’re trying to use that to come up with financial ratios or financial metrics. How is our business doing and how can we how can we improve what we’re doing using these records? Part of that is budgets and forecasts. Like looking at a corn budget for ‘23, for example, but also a cash flow forecast. You know the fall of ‘23 looked like for different corn and soybean prices? That would be an example of something that chief financial officer would do. Of course, they could also design reports, but that’s not the main thing they’re doing. Yes, they can develop an income statement and a balance sheet. But what the main thing they’re doing is really taking those records and figuring out what those records are saying to us. And then using that also for budgets and forecasts. The CFO is many times looking forward rather than back where we use, but we use historical information to make these projections and decide where we want to go, what changes do we want to make?

James Mintert:
So, the CFO role is really about interpreting those results from the past and using that to make some assessment of what’s likely to happen if the farm continues in its current role and its current operations, and also start thinking about what would happen if we made some changes. Right.

04:11 – Strategic Direction
Michael Langemeier:
As usual, you just stated that more succinctly. I went more around the barn.

So let’s think about strategic direction a little bit more. Think about financial statements, financial records as a roadmap for where we want to go in the future. We need to ask questions. We need to formulate questions related to that. First of all, is our form profitable? One of the things you absolutely cannot do is think about your strategic position if you don’t even know what your current profitability is or your current profitability is relatively low. You probably should correct that problem before you start making expansion decisions or things like that or change product mix. So, we really need to see how profitable our farm is using some of these historical numbers and then we can use that to determine whether we have a competitive advantage.

I always say the proof is in the pudding. If you think you have a competitive advantage (we’ll talk more about competitive advantage later in this podcast), but if you think you have a competitive advantage, you better have above average profitability or you don’t have a competitive advantage. Those go hand in hand. Also, it’s important to think about profitability, competitive advantage.

If we think about resources, what resources do we need to expand and think about resources very broadly, farmland, machinery, grain bands, buildings, human capital, you know, do we have enough people in the business to be successful if we want to grow this business? Do we need to hire someone? Do we need to bring in another family member to make this business successful?

James Mintert:
So, you know, Michael, you’re thinking about competitive advantage. And one of the things that occurred to me while you were saying that was that’s really where things like benchmarking come into play, right? If you’re doing some benchmarking, you can start identifying your competitive advantage. One way, obviously, is what you mentioned, which is above average profitability. But then the next thing is to think about as you start to drill down a little bit, compare your farm operation to other farm operations using various farm recordkeeping systems. There are several that we typically reference here at Purdue. Right?

Michael Langemeier:
Yeah. And usually when I talk about benchmarking, I start with the whole farm. So, what is my profit margin compared to average profit margin? And there’s data available from University of Minnesota, FINBIN and other data sources, like the Farm Business Farm Management Association in Illinois. We can come up with some benchmarks, but this also leads to benchmarks for crops.

If, let’s say our whole farm profitability is not as good as we think it needs to be. If we want to improve, then you start drilling down and say, what’s holding me back? Is it my corn? Is it my soybeans? Is it a swine enterprise? What’s holding me? What’s holding my profitability back and start analyzing those individual products or individual enterprises.

James Mintert:
And Michael, you know, one of the things that I think leads a lot of farms to start questioning their strategic direction is the point you brought up about is this farm large enough and profitable enough to bring another family member back into the operation? That’s when it really kind of comes home to roost for a lot of people with respect to if we’ve got a family member who would like to come home and join this operation. Our challenge is, is it large enough and profitable enough to make that really possible, Right?

Michael Langemeier:
Yeah, that makes a huge difference. I mean, if the farm is not very profitable, you’re going to need to do something different than if the farm is quite profitable. It’s an obvious point. It’s not just size you’re looking at when you’re thinking about bringing something back. It’s size and margin.

And ideally, you’ve big enough to bring somebody back. So, there’s enough acres, enough production there to bring somebody back. But that’s only part of the picture. It’s also what is that profit margin. If my profit margins are really low, you’re going to need a lot more acres in order to bring somebody back compared to a case where your profit margins pretty good and you don’t need as many acres because you’ve got a good profit margin.

07:47 – Duties of a CFO
James Mintert:
So Michael, let’s think a little bit about some of the formal duties of a CFO and think about how that applies in a farm setting, because normally when you think about the term CFO, you’re thinking about a larger business, right? And corporate structure, etc.. And what we’re talking about now is, is taking that CFO concept and applying it at the farm level. So the first thing people talk about is something called control duties. Let’s talk about what that means on a farm.

Michael Langemeier:
These are the fun things, at least I think they’re fun things. Keeping accurate records, both whole farm and enterprise. Making sure that we have accurate cash records. And then we also have cash records associated with individual enterprises. So, we know what our corn seed cost versus our soybean seed. And same with fertilizer, repairs, and all these different costs.

Also, part of the control function is to prepare the accurate financial statements, making sure our balance sheet is up to date and accurate. For example, farmland values, make sure that we’ve got a reasonable farmland values in that balance sheet. Another thing that’s extremely important, if you have crops, for example, that you have good inventory numbers that we know to a very accurate degree, how much corn we have in storage, how much soybean we have in storage. That makes the balance sheet more accurate. If you have more, if you have livestock check, you’ve got accurate accounts on the number of livestock that are on the farm. That just improves the quality of the balance shee. Without good cash records, without a good balance sheet, it’s very difficult to measure financial performance. And so that’s all part of the control duties.

Moving on to the Treasury duties. This is just as important. Let’s say we’re making good money and our net farm income is strong. And once we take money out for the for the operator-owner withdrawals, we call the directly net farm income and owner withdrawals retained earnings. We’ve got a strong retained earnings. Then the CFO, along with other members in the business, thinks about what should we use of retained earnings for. Should we save some of that money in retirement accounts? Should we invest in farmland? Those are huge decisions. But also, should we use some of that money to buy farm machinery? Maybe there’s some new precision agriculture technology that would really help us at our farm. Maybe we could buy some machinery that has that technology, you know, so we can move forward and improve our efficiency.

Also, buildings and grain bins. All of these. There’s a lot of different things to add to invest retained earnings in. If you have those retained earnings and how you make that decision is going to be very important to how that farm’s going to grow and how the sustainable at that farm is going to be.

James Mintert:
Yeah. So, one of the things I wanted to maybe dwell on just a little bit here, is this retirement savings option. And that’s a tough one for a lot of folks. And we think of it, you know, we kind of put really two broad categories there. One, farmland investing those retained earnings and farmland as something that would serve as a retirement vehicle later on. Right. Versus some off farm investments. And that’s a challenging choice for a lot of folks. Part of that ties back to is this farm going to continue beyond the current generation? And that’s going to influence that decision about whether you should be investing in farmland versus off farm investments? Right?

Michael Langemeier:
Definitely. That definitely the case. If you’ve got some people identified, young family members identified, that might come back to the farm at some point down the road, it makes a lot of sense to invest quite a bit of that retained earnings in farmland. If you’re a sole proprietor and it looks like you don’t have any coming back to the farm, then I think there’s nothing wrong with investing in farmland, but you also should think about all investments, not just savings for one type of asset. Mutual funds.

James Mintert:
So one of the things that’s really different about a CFO role versus an accounting role is the importance of forecasting, right? A CFO is really going to be the individual on a farm operation who is going to be responsible for at least initially generating some forecast of what the business is likely to do based partly on what we’re currently been doing. No change in current operations. And then also starting to think about, well, what would happen if we made some changes? Maybe some alternatives, some alternative scenarios, which is something I know you like to look at a lot.

Michael Langemeier:
Both of us have seen this actually happen on actual farms. We’ve seen where there’s somebody that does a good job of keeping those records and then they share that information with the entire board, if you will, or family members. Together they think about, okay, what should we do next? Do we need to tile this piece over here or do we if we have an opportunity to rent an additional 160 acres? Are we in good position to rent that additional 160 acres? Well, it looks like there’s going to be 130 acres down the road that’s going to be for sale in the next year or two. Are we in position to buy that ground? And so that’s the power of having good financial records. If you can make better decisions regarding those major changes in the operation, you have good financial records.

James Mintert:
And one of the things I think we want to differentiate a little bit here is the role of a chief financial officer versus a chief executive officer. The chief financial officer is in charge of making the forecast based on the data that’s available, not necessarily just making the decisions. Right. And I think in some farms it might be the same person. The CFO is also the CEO, but in many cases, as you mentioned, it could be other family members. Sometimes it could be some key senior employees that might be serving in that role. It’s not a function of the CFO automatically making the decisions. It’s gathering the information and generating forecast and saying if we do this, this is what’s likely to happen. If we make this change, this is what’s likely to happen.

Michael Langemeier:
And a lot of farms have rules of thumb that if it’s a relatively small purchase, anybody in the business can go ahead and pursue buying that input or that asset. But typically, if it comes to something bigger, a tractor, you’re buying land, something like that, that’s kind of a joint decision. So, the CEO might be a group of people. You might be like, again, going back to, let’s say there’s four brothers farming together. It might be the four brothers talking to one another. The CFO is sharing what the financial metrics look like right now, using that information, should we go ahead and buy that land that might be coming up for sale a mile or two from us?

14:38- CFO’s Key Financial Performance Area: Risk & Financial Documentation
James Mintert:
So let’s talk about the five key financial performance areas that a CFO needs to kind of focus on. And the first one is going to be what we call risk in financial documentation. And the first thing that pops up to mind to me when I hear the word risk is thinking about things like insurance coverage and risk management in general, right?

Michael Langemeier:
Yeah. Usually this would be at least crop insurance. Now, risk management, it may or may not include marketing. In fact, on the larger firms, it probably doesn’t. There probably is another person that’s in charge of the marketing. But again, they’re working together. They’re using their financial information to help us with the marketing decisions. And so that’s kind of the role of the CFO is to work with that person that’s doing the marketing, but it is some of the accounting systems making sure they’re in place, that we have good cash records, we have a solid balance sheet.

I keep talking about those things. That’s what you really need if you’re going to measure profitability is good cash records and a good balance sheet. So that’s also part of it. Using that information to come up with some financial ratios like the profit margin, comparing that to other forms to see where we stand, but also the planning part, you know, what should we do this year? Should we grow 50% corn, 50% soybeans, or we should we maybe grow a little more soybeans and corn this year? Making those kind of decisions with our records.

James Mintert:
So when you say accounting systems, let’s back up for just a little bit and think about what that means for a lot of people. That’s going to be some software, right? QuickBooks is a pretty commonly used one, but it’s not the only one. But you’ve got to pick one. And for example, if you’re going to use QuickBooks, what are some of the decisions that CFO needs to make with respect to making sure they’ve got a good accounting package that they can use to present results?

Michael Langemeier:
Yeah, that’s a good question. A lot of software like QuickBooks is going to be really good for the cash records. I’ll talk about what you need to do you with the QuickBooks to make sure those cash records or IRA are providing the information you need. So you’re going to have to have another spreadsheet or something else that is going to help you with the balance sheet. A lot of people will use a software like QuickBooks for the cash records, and then they’ll have the balance sheet maybe on Excel, you know, keep that information in a separate place. And there’s nothing wrong with that. As long as they’re both accurate, there’s nothing wrong with that. You don’t have to have an accounting system that does everything. That’s not a must. That’s okay if you have that. But you can get a long ways by having a good cash record keeping system software and then keeping the inventory information in a separate place, like a spreadsheet. Now, when it comes to the cash records, one of the things you really have to think about is what I call the chart of accounts, and you want to at least have the chart of accounts that matches the Schedule F. You need to make sure that seed is clearly identified separately from the other expenses, fertilizer and just go down from there with different expenses on a Schedule F. Make sure you at least have those categories in your chart of accounts. Now, once you’ve got that, then you can start maybe having a more sophisticated chart of accounts rather than just saying seed, you’re actually identifying corn seed versus soybean seed. But I always say, you’ve got to walk before you run. And so, I always think about whole farm records first, make sure that system is in place and be accurate. Then add in the enterprise records.

James Mintert:
Yeah, good point. So, the other thing is to think about some financial planning, right? Capital budgeting is going to be a big part of what a CFO does. Tell us what you mean by that capital budgeting.

Michael Langemeier:
Really, capital budgeting is a fancy word for just looking at benefits versus cost. So, if we’re going to buy machinery, what are the benefits associated with buying that machinery? Can we quantify those benefits? And of those benefits coming, are the benefits immediate or those benefits spread over ten years? That’s all part of the capital budgeting using time value of money. All that means realizing that as the benefits are down the road, seven, eight, nine years from now, we need to discount those because those benefits are not in today’s dollars. And so that’s really what capital budget is doing for us. It’s taking into account the timing of benefits and cost, but also, it’s just a sophisticated way to analyze the benefit, of course, of buying anything like grain bins, farmland, machinery, buildings, any asset we might be thinking about that we’re thinking about purchasing on the farm.

James Mintert:
So one of the things that I think of when you think about capital budgeting in the current environment with respect to machinery, is the changing technology and how much benefit you might gain from that new technology and that new implement – that new tractor, new combine, etc.. And that’s a little bit of a challenge in terms of assessing what kind of a productivity change you might get. But I think it’s important to think about that, right? When you think about those.

Michael Langemeier:
Usually when you’re thinking about technology, there’s two things you have to quantify, at least two things you need to quantify. First of all, is there any production benefit? And there usually is. And so, there is, there a yield benefit and try to measure that, to quantify that maybe using some different yield numbers, do some sensitivity analysis. And then the part that’s probably a little easier sometimes is the cost savings. You know, how much money are we saving by investing in this cause? You say, well, this is an expensive equipment. What do you mean by cost saving? Well, you’re probably saving some labor. Any technology you buy is probably going to be bigger. And so, you could cover more acres with the same person. So there’s always some kind of cost savings that you also need to quantify in addition to the production. So, I encourage people to try to quantify both of those. And if you’re a little uncertain on either one of those or both of those, use sensitivity analysis. What if, how much production benefit do I need in order to make this machinery attractive? How much cost savings do I need to make this asset beneficial to my farm?

James Mintert:
But, you know, if you think about some of the new technology with respect to precision agriculture, there’s been lots of things that would benefit their right. People talk about the opportunity to reduce, for example, herbicide usage because of minimizing overlap. Same thing with seed with planters, etc. So, there’s been lots of opportunities. The challenge is to think about it in a way that is realistic. Make sure your projections are realistic when you’re plugging those in. And then the last thing to think about with respect to financial planning, Michael, is managing working capital. And this is something we talk about a lot here at the Center for Commercial Agriculture with the idea that people need to be monitoring their working capital and thinking about how they’re going to manage that. Because that working capital is really what provides farms resilience.

Michael Langemeier:
Yeah, and this is where this can get very, very complicated. I’ll start with something that’s relatively simple or straightforward. When we think about the relationship between current assets and current liabilities. Current assets are things like crop inventories for crop farm. That would be a big current asset. Also cash, if there’s a we have quite a bit of cash in the business, that would also be a very important current asset, current liabilities or any operating debt. We might all but also the current portion of term debt. So how much term debt on our land machinery buildings is due within the next year. That’s current liabilities. And a rule of thumb that we use for any business, including farms, is 2 to 1. We like to have twice as much current assets as current liabilities. Why? Well, what happens if corn price is $5 next year instead of $6? Well, if it’s $5, we’re probably going to need that cushion to make sure we can repay debt. You’ll pay the operators and everything else that we need to do with that net farm income. And so that’s why we want 2 to 1 in terms of current assets and current liabilities.

And this is where it now gets complicated. Some people are comfortable with fairly tight liquidity, just 2 to 1. That’s fine. Some people want a little more cushion than that. And, sometimes people want a little more cushion than that, particularly with cash, because if you have very strong liquidity, it increases your ability to respond quickly to an asset that may be coming up for sale, i.e., you know, where I’m going with this, farmland. If I have what I call deep pockets, strong liquidity, I’m in a much better position to make a good down payment on some farmland and make it happen. Whereas if I have tight liquidity, that might be difficult. Coming up with a down payment that’s big enough in order to buy that farmland.

And so one of the things I always tell my students is there’s not a strong relationship between liquidity and profitability, but liquidity does open up some opportunities that it’s hard to put monetary dollars on, such as this flexibility. And so let’s take it a little broader here. Sometimes investors that are looking at, companies, now we’re going outside the agriculture a little bit, but I want to do it for analogy purposes. Sometimes investors are looking for companies that have strong cash. Why? They’ll give a premium for a company that has strong liquidity position because that company has flexibility to make asset purchases and do it very quickly. It’s kind of the Warren Buffett model. I have deep pockets and if something comes up for sale that looks like a bargain, I can move and buy that asset. The same is true with Forbes.

James Mintert:
So, you kind of represented that from the positive side, the opportunity side. The flip side of that is it provides resilience, right, against stress. So if we have a downturn, that strong working capital position enables you to weather the downturn. And of course, we’ve seen periods in the past when people that didn’t have a strong working capital position found themselves in financial difficulty very quickly with a financial downturn. So in a way of managing your ability to respond and be resilient with respect to stress.

24:40 – CFO’s Key Financial Performance Area: Capital Structure & Debt Service
James Mintert:
So, let’s talk about capital structure and debt service. That’s really got several layers to it, Michael. One of them is thinking about just your cost of capital, which is obviously interest rates, which has been a topic of great concern here lately. But also with respect to your equity component, right.

Michael Langemeier:
This is a topic that can again, you can write a textbook on these things. But I’m going to try to keep this relatively straightforward. When you’re borrowing money, your object, and this is a part of what capital budgeting does for you. It answer this question at least from a pro forma standpoint, it doesn’t always, you know, when you look back, it always doesn’t look like a good decision. But at least moving into the buying an asset, it looks good when you borrow money. You always want the rate of return on those borrowed funds to be higher than the interest rate. And so that’s something you’re always looking for when you’re buying assets. That’s why capital budgeting is so useful, because it almost forces you to think that way.

You’re not going to move forward with an asset purchase unless it looks like the you’re the money you’re going to earn by investing that asset exceeds your interest costs. And so that’s a fairly simple concept, but it can be fairly difficult to pull off because we know there’s uncertainty and sometimes when you look in hindsight, you see, well, that debt didn’t pay. But the main thing is when you’re moving forward that that it looks like these new investments are paying for themselves with some extra money. And so that’s important concept. And then this also covers things like liquidity and leverage. You’re thinking about, you know, what liquidity position am I comfortable with, how much do I need for the reasons that we’ve just kind of been talking about. It also fits into leverage or debt to asset ratio. And I always say the debt to asset ratio is very personal or specific to the business. Some people are very comfortable with a debt to asset ratio that’s 40%, meaning that meaning that the lender basically owns 40% of my assets. I own 60%. Others would like to see that leverage down to 20%. You know, that the lender only is borrowing on 20% of the assets. And I own the other 80%. And so, it’s very personal. A risk averse person likes a low debt to asset ratio. Some that’s not quite so risk averse, likes the higher debt to assets ratio. Well, we got to remember what we’re giving up when we have a low debt to asset ratio, you’re probably not taking advantage of as many opportunities if you’re to conservative in terms of borrowing money.

But what do you? There’s also positive spin to that. If I don’t borrow as much money, and this is why some people don’t like to borrow as much money as others, I have less chance of losing the asset that I’m purchasing. You know, in extreme case, if you’re borrowing a lot of money to buy an asset and it doesn’t work out. That decision doesn’t work out, you might have to sell that asset. So obviously if you have a higher debt to asset ratio, you’re more likely to face a situation where you’re going to have a shortfall of cash. And so leverage is really a double edged sword. It can increase profitability, making an increased risk. And so businesses have to really analyze what they’re comfortable with in terms of a leverage or debt to asset position. There is no one answer or benchmark that really helps us with that. The other thing I talk a lot about in extension presentations and also in my finance class is the whole idea of repayment capacity. This is something a lender always looks at, but I think it’s important for us to look at too. Is my net farm income strong enough to cover the amount of money I want to pull out for family living, to pay term debt and to replace assets? You’re trying to figure out whether that net farm income is big enough to do that. And some fairly simple calculations, if you have good records, can really help answer those questions.

James Mintert:
And get back to your concept discussion of leverage. Michael, you know, one of the things we’ve observed is over time, some farms that were pretty conservative with respect to their use of leverage. But the downside of that was they weren’t able to grow rapidly enough to really sustain themselves over a long period of time, particularly when it came to bringing back a new family member.

Michael Langemeier:
And that’s particularly true at the 20% debt, as it may constrain you from bringing somebody back if you have a goal which is rather extreme and we don’t see that very often with commercial farms or full time farms. If you have a goal of having really low debt to asset, i.e. zero, you’re not going to grow very fast. You just can’t, you know, generate enough retained earnings to expand.

Retained earnings to buy farmland, to replace machinery. And so, a lot of times you need at least some debt. And so that’s why I always say when you borrow money just try to figure out whether that’s the right decision. Is there’s enough benefits associated with borrowing money to buy that asset that’s going to help pay for that asset.

James Mintert:
So the last point here, Michael, is one that we’ve kind of stayed away from a little bit. But I think sometimes when we start thinking about leverage and capital budgeting, people focus maybe a little too quickly on tax considerations, but that is an important component.

Michael Langemeier:
It certainly is. But when we think about making decisions related to taxes, we always have to think about if we’re buying a machine with accelerated depreciation. Are the benefits of buying that machine outweighing in the cost? And part of the benefit is tax considerations. But that machine also better be increasing efficiency, having some cost savings or maybe that’s not the best decision to use accelerated depreciation to buy that machine. So, they work hand in hand. Taxes is important, but so is looking at capital budgeting. The benefits of the cost associated with buying an asset. So, make sure make sure you’re doing both of those.

30:47 – CFO’s Key Financial Performance Area: Profitability
James Mintert:
So let’s talk a little bit about profitability. And there are some key metrics that people like to use and we recommend using to assess the farm’s profitability. And you might just itemize those as we’re not going to cover these in a lot of detail here today. But keep in mind that we’ll do that in some future podcast.

Michael Langemeier:
And we also have information on the Center for Commercial Agriculture website related to calculating all of these ratios, along with an example case for how we can calculate all those ratios. I’d like to encourage people to look at that. But the most important one in my mind is profit margin. How much money are we making on our sales? Is that 5%? Is that 10%? Is that 15%? And that’s the first metric you want to look at. If you want to look at the second one, the one that I like to look at next is something called the asset turnover ratio. And what that’s really doing, is (it’s fairly simple to calculate) its gross revenue or kind of my gross sales, if you will, adjusted for inventories related to the asset base. And if you’re doing a good job of utilizing your assets, that asset turnover ratio is going to be higher rather than lower. And so those are the two I start with. Once you have those two ratios, you can calculate some other ratios like return on assets, return on equity, you know, fairly simply.

James Mintert:
So, you know, one of the challenges I know a lot of our listeners probably haven’t been computing those ratios, but one of our challenges, I think is, you know, when you do financial analysis, you really want to try and assess whether or not you can improve profitability, right?

Michael Langemeier:
Yeah. And actually, measuring the profitability is simpler than trying to do something to improve the profitability. But you got to start someplace. And a lot of times you don’t even know where the bottlenecks might be in your operation until you calculate a profit margin. Start looking at enterprise profitability. And it’s just the first step in trying to analyze how to make improvements.

James Mintert:
Yeah, I mean, I think, you know, one of the points to remember is if you don’t measure it, it’s going to be hard to actually try and improve it.

Michael Langemeier:
That’s actually from an engineer friend that I have. They always say that if we got to, you know, engineers like to measure things and they always say, how can you manage something you can’t measure? And they’re right. You can’t manage something if you don’t measure. If I don’t know that my corn enterprise, for example, is holding back my profitability, that’s a problem. You guys. That means you’re not making changes that corn enterprise to try to improve profitability. And I’m not just picking on corn. It could be any enterprise on the farm. You just need to measure that. And same with resources. You need to look at your labor situation. Do I have not enough labor? Do I have too much labor? How do I know that when you use some financial metrics to try to measure your labor productivity in labor efficiency?

33:40 – CFO’s Key Financial Performance Area: Size & Growth
James Mintert:
So let’s talk about size and growth. That’s the fourth component here.

Michael Langemeier:
And this goes back to my replacement margin. We want to know whether we have enough money to pay the operators to pay term debt. And then we also want to know, can I replace assets in a timely fashion? One of the things that I found when I worked at Kansas State and worked with the Farm Management Association and also looking into the FINBIN data and the farm business farm management data in Illinois is there’s quite a few farms that really don’t. Once you start paying for the operator, the owner withdraws living expenses and the term debt. There’s not enough cash flow back there to timely replace machinery that’s wearing out. And so that’s a very important question. Do I now have enough cash flow to replace machinery? And we’d like to go further than that. Do I have enough retained earnings, cash flow so that I can expand?

And so it’s kind of in steps. Do I have enough money to cover operator labor and term debt? Then if the answer is yes and hopefully it is, do I have enough money to replace assets? And then finally, do I have enough money to expand? That’s internal, you know, that kind of information? It’s hard to decide whether to bring somebody back to the farm because we really don’t know if we can afford to bring that somebody back. And so, we talk about is a business large enough? That’s how I think about it. What does your cash flow situation look like? You know, is there enough cash flow there to not only pay for this person, pay this person a wage, or have them split the profitability in some fashion. Is there enough money that we can rent additional acres? Can we buy farmland? Can we buy machinery that we’re going to need to do to make sure we have a long run, viable operation? And so this all kind of works together, again, without these financial metrics is very difficult to figure out whether we can really bring somebody back.

James Mintert:
And that kind of takes us to the issue of, you know, one of the challenges for a farming operation, it’s pretty clear over the decades is you have to grow. And when you compute the financial metrics we’re talking about here that leads you down the path where you can start thinking about how rapidly does this farm need to grow to make it sustainable. And particularly you think about passing it on. For example, to the next generation.

Michael Langemeier:
Yeah, we all we know that we need to grow. It’s just the real question is how fast. How fast do I need to grow to make sure that the people that want to join the operation, we want to join the operation, are able to join the operation. But at the same time, we know growth can be kind of chunky. It comes in chunks, and you’ve got to be a little careful you don’t grow too fast. That’s why you also need to consider your liquidity and leverage position or debt to as a position and make sure you’re not growing too fast. You’re not draining your liquidity and you’re not increasing that debt to asset ratio in an uncomfortable range. And so, again, it gets very complicated when you start to think about that.

36:41 – CFO’s Key Financial Performance Area: Creating Shareholder Value
James Mintert:
So, one of the things that we also like to talk about is creating shareholder value. In other words, creating value for the folks that actually own the business. And economists like to talk about something called economic profit. And I realize that’s not a term that a lot of farm operations are comfortable with, but really economic profit in it’s most broadest sense is the assets employed in the firm being earning a high enough return to keep them in their current use. Right. And so, the question to do that is, well, how do I actually compute economic profit on a farm?

Michael Langemeier:
Yeah, I was talking about the importance of cash records and a balance sheet here. We have to go a little further than those records to do this. We have the cash cost. Obviously, it’s very important that they’re included in this calculation of economic profit, but we also have to cover what we call opportunity cost. And opportunity cost is what could we get for that asset if we rented the asset out? And so that would be true in machinery. We have $1,000,000 invested in machinery. If I didn’t have $1,000,000 invested in machinery, what could I get? What kind of earnings could I get for that million dollars? The same with farmland, right? If I have $5 million invested in farmland, what kind of earnings could I get for that $5 Million if I didn’t own the farmland?

So that’s the kind of opportunity cost we’re thinking about here, making sure that the machinery, buildings, and grain bins that we own are receiving a rent, if you will. And then also the farmland that we own is receiving a rent and seeing if these are the cash costs and these opportunity costs are being covered.

James Mintert:
And again, from a long run standpoint, not only do you have to cover these essentially enough of a return to those assets to generate an economic profit, but if you don’t do that, you’re really not going to have an opportunity to expand.

Michael Langemeier:
And just to reemphasize the importance of benchmarks in the research that I’ve done over the years, there’s a 25% of the farms are earning an economic profit long term. You know, when we when you think about microeconomics from a textbook standpoint, we’re taught that economic profit is fleeting, meaning that it does it’s not sustainable. That’s true. If all farms looked identical, all farms don’t look identical. We’ve got 25% of the people out there, at least that’s kind of a minimum figure, that they’re such good managers that they’re making decisions that’s ensuring that they have a long run economic profit. And that’s truly amazing that we do see the farms that are that good in terms of earning a profit.

The other thing that we need to think about, we took a think about shareholder value is in addition to looking at net farm income profit margin, the asset turnover ratio, one of the things you can do with a good balance sheet is you can see how much did my net worth increase in in this year and why. And really understand why did it increase. And that’s difficult for farms compared to some other businesses because we have so much money invested in farmland, that’s an appreciating asset. And so we want to know was my net worth increasing because my land values are increasing. That’s they’re typically increasing. They do come down once in a while, but usually they increase or retained earnings. And it’s a very important question to ask, is hopefully it’s both, that we’re getting some land value appreciation in an average year and we’re also seeing positive retained earnings. That’s also increasing our net worth.

James Mintert:
And so, when you mentioned that you’re looking at some of the farm recordkeeping systems, 25% or maybe a little more of the operations are generating a positive economic profit. Those are the farms that are expanding.

Michael Langemeier:
Definitely.

James Mintert:
And I think sometimes people ask that question to themselves, well, how can somebody do that? Well, for whatever reason, whether it’s cost control, margin control, those farms that are generating economic profit and they’re able to expand as a result, Right?

Michael Langemeier:
Yes.

40:47 – Competitive Advantage & Business Strategy
James Mintert:
So, let’s kind of wrap this whole discussion up, Michael. Talking a little bit about what the farm’s long run business strategy is. And really that’s boils down to trying to figure out what your farm’s competitive advantage might be and whether or not you have one to start with. Right.

Michael Langemeier:
Typically, this is a lower cost per unit. It’s not just lower cost, but it’s lower cost per unit. And so rather than having, right now we’re crunching ‘23 corn budgets, for example, and we talk about those in our webinars, rather than having $5.50 corn breakeven price, maybe I have a $5 breakeven corn price. That’s where I say the proof is in the pudding. If you have lower cost per unit for your different enterprises, that truly is a competitive advantage. And so that’s been our typical strategy. Usually, we get lower cost per unit by expanding, but there is some, you know, medium size operations that also have lower cost for whatever reason. They’re doing a good job of management and they have a lower cost. What’s really changed in my career and that spans back a ways, I know, 30 plus years, but what’s really changed in my career is the importance of delivering greater value to customers. And I think you’ve seen that too, Jim. The relative importance of trying to produce products that get a slightly higher price. In Indiana, we have a lot of examples like with white corn, waxy corn, popcorn, and seed soybeans. The seed corn in north-central Indiana. There’s a lot of different products that we can think about producing that give us a slightly higher price giving us that competitive advantage, that above average profitability.

James Mintert:
Yeah, I think, you know, looking at the farms that you and I have had an opportunity to interact with closely over the last decade or so, many of them, in fact, the vast majority of them and at least a portion of their operation, are doing something other than producing just basic commodities. Right. So, they’re putting in some extra effort, some extra managerial expertise, for example, and using that as a way to generate a return that’s higher than what they could earn on a straight commodity product. And so one of your challenges to think about whether or not you have an opportunity like if you’re not doing that currently. Your first blush you might say, well, no. Well then you need to step back and think about might there be an opportunity? And you mentioned several things, it might even be an auxiliary enterprise. You know, one of the things we’ve seen a number of farms do is engage, for example, in drainage. Yeah. So lots of things to think about there. You know, when you mentioned seed corn, waxy corn, white corn, etc., there’s lots of opportunities beyond that as well. And so, the question is, does it fit? Your operation is probably going to need to change.

It’s going to mean more effort, more managerial expertise. The question is, do you have that ability and if you can use it to extract some positive return?

Michael Langemeier:
And stepping back here a little bit, a lot of times it means looking at the major decisions we make on the farm and make sure that we’re, you know, if we don’t have that expertise, to make a good decision, that we get some help to make that decision. The examples are crop insurance. Do I have a crop insurance agent that clearly explains the different products available to me. And I do the best. I get the most bang for the buck. I protect risk without spending a fortune doing so. You’re in your area, marketing, if I don’t have the expertise, is there some way I can leverage some help you know, from a professional to help us with marketing. So, think about some of these major decisions that you make. Asset purchases, crop insurance, marketing. Do we have the expertise to really excel in those, or do we need to bring in some help to help us excel in those? You don’t want to let any of those slip.

James Mintert:
Well, Michael, I think we’ll wrap it up there for today. And I just want to encourage our listeners to check out the financial management series, which is available on the Purdue Commercial Agriculture’s website, which is purdue.edu/commercialag. If you go to the top menu bar and click on series, you’ll discover there’s several different series to choose from, and one of them is the financial management series, and you’ll discover we’ve got a series of publications that you can use to improve your financial management skills.

And so that wraps up today. On behalf of the Center for Commercial Agriculture and my colleague, Dr. Michael Langemeier, I’m Jim Mintert. Thanks for joining us.