Operating Efficiency Among Agriculture Borrowers a Comparison of Four Farms

By Tim Ohlde, Country Banker

Agriculture is a cyclical industry and, recently, this has been evident across all the commodities. Monitoring Financial Efficiency ratios is key to understanding the health of operations particularly in times of transition between cycles.

Although there are several efficiency ratios to choose from, the Operating Expense Efficiency (OEE) ratio is one of the best to start with. Tracking the proportion of expenses to revenue gives keen insight on asset utilization, management aptitude and discipline. In this case, less is more; a lower ratio (percentage) is the goal so that expenses are lower per dollar of revenue.

The formula for the Operating Expense Efficiency ratio is:

Total Operating Expenses (Excluding Depreciation and Interest) divided by Gross Revenue In essence, tracking how many cents of operating expense it takes to produce a dollar of Gross Revenue.

To illustrate the value of the OEE ratio, data was gathered for four farms to display changes in efficiency as they moved toward, through and beyond the most recent super cycle. The four farms all include a cow calf operation and approximately the same percentage of acres in a mix of dryland and irrigated row crops. They could each be dubbed a typical midwestern farm. It is important to note that all four borrowers are using accrual adjusted Income Statements. Their data quality is high and reflects true profitability. If you have not moved to accrual adjusted Income Statements, it is a foundational piece to enhanced quality analysis.

The chart below displays three-year averages of the OEE ratio for each of the four farms.

When compared side by side it is evident that Farm One emerged from the super cycle, even more efficient. While the other three lost significant efficiencies. Which begs the obvious question, “What strategic decisions allowed Farm One to emerge from the super cycle with increased efficiency?” Based on knowledge of the operations three key strategies were used:

• Consistently marketing crops and livestock two years ahead,

• Reconfiguring capital to deploy it the most effective way, while resisting the urge to completely upgrade machinery and facilities with the enhanced revenue, and

• Close management of expenses by conducting a line-by-line review each year.

After developing and reviewing this case study, several things were evident. First, financial information doesn’t lie, there are tactics available to improve the efficiency ratio even in a super cycle. Second, you can’t take your eye off the ball during good times, for even one year. Farms two, three and four all saw dramatic impact on the average of the efficiency ratio post super cycle. Exerting influence on that negative move were inconsistent and/or no marketing and decreasing focus on controlling expenses. Just one year of skyrocketing expenses leaves a large impression. And third, times of high prices can disguise inefficiencies. Out of the norm government payments such as the ad hoc ones the last few years can skew the revenue picture as well. General ag lending statistics show that in 2020, many borrowers covered their debt service exclusively with government payments. Without further study of the numbers, one might assume that the operation was doing very well.

Can you review the trend and determine what specific activity caused the impact? Of course not, but it does alert you to a possible trouble so you can start digging in to find out what happened.

Because driving down the expense side of this equation is challenging. And, because borrowers sometimes believe their commodity prices are out of their control, how do you convince borrowers to work toward improving the Operating Expense Efficiency ratio?

• Engage a marketing plan on 100% of sales,

• Conduct an annual line-by-line expense review and evaluation, zero-based budgeting for agriculture, and

• Reconfigure capital allocation for maximum profitability.

If your bank is new to ratio analysis or is not used to discussing ratios with borrowers, the OEE ratio is a great place to start. It is easy to calculate and understand and is also meaningful to borrowers. You can use this ratio to strengthen your borrower relationships by offering added value through the insights that come from this ratio. Consider the following positive ways to launch those discussions -

• Borrowers can use this ratio to challenge themselves. The ratio is an indicator of how management and resource base are working together to make maximum impact (MxR) squared.

• The range in which the ratio falls does not change; regardless of change in expenses and/or revenue, look for stability in the range or a decreasing ratio. Begin by reviewing the range and setting goals to achieve.

• Create a benchmark with this ratio against which you match up expenses and revenue on Pro Forma Cash Flows. There are benchmark suggestions below.

• If borrowers are eager to improve efficiency, help them see that it will take:

• Significant management adjustments,

• Changes in resource composition, and

• Adoption of new practices; for instance, moving toward no-till and away from maximum tillage.

• Put the level of revenue and expense in context. Help borrowers see that the cost structure of today’s operations is substantially higher. Even small swings in expense can have a dramatic impact on margins.

Your bank may also be using ratios to rank borrowers within your portfolio or as part of loan pricing and scoring. If that is the case, the following benchmarks may be useful. They are widely accepted and provide a good starting point for a dialogue about how these ratios could be part of your scoring or pricing and what your bank’s lending policy will be. Please note, there is a recognized difference in benchmarks for operations that have mostly owned versus mostly rented or leased land.

As agriculture lending continues to evolve and becomes more analysis focused, great lenders will work in partnership with their borrowers to encourage:

• Deep, quality analysis, including accrual adjusted Income Statements,

• Knowledge and implementation of risk management/commodity marketing,

• A focus on education – both parties need to keep learning,

• A keen understanding of each business enterprise, and

• Striving toward above-average business IQ

Efficiency is never more important than in times of tight margins, but don’t overlook how it can also help borrowers truly capitalize on the upside of supercycles and other circumstances that provide openings for extraordinary financial success. Ratio analysis is the tool to uncover those opportunities and to position borrowers to act.

About the author: Tim Ohlde is CEO of Country Banker Systems. He can be reached at timo@countrybanker.com. Country Banker is a loan analysis software program designed by bankers for bankers to use in an intuitive and efficient way. Ohlde is also CEO of Elk State Bank. Both companies are based in Clyde, Kansas. IBA Associate Member