Calculating rate of return on farm assets

The Dairy Excel 15 Measures of Dairy Farm Competitiveness bulletin was published by Ohio State University extension to provide dairy farmers the ability to evaluate business competitiveness using financial and production information. Measure Seven, Profitability, as measured by Rate of Return on Farm Assets (ROA), is discussed in this article.

How is ROA calculated?

Net Farm Income + Farm Interest Expense – Value of Operator’s Labor and Management/Total Farm Assets x 100 = Rate of Return on Farm Assets.

Example calculation:

$312,000 Net Farm Income

+ $52,000 Farm Interest Expense

– $150,000 Value of Operator’s Labor and Management

= $214,000 Return on Assets

$214,000 Return on Assets/$2,490,000 Average Total Farm Assets X 100 = 8.6% Rate of Return on Farm Assets.

Competitive level

We consider 10% to be the competitive level for rate of return on farm assets. ROA is useful for determining what the assets invested in your operation earned. The higher the ROA, the more profitable the farming operation.

If you use current market values to determine the worth of your assets, you can use the ROA to compare your earnings to those of other businesses for the same time period. The ROA also represents the opportunity cost of having your assets invested in the dairy business as opposed to investing in another business or other investment opportunities that might generate a higher or lower return.

Factors affecting the rate of return on farm assets include the following:

1. How assets are valued,

2. Profitability of the farm business,

3. Level of owner withdrawals for unpaid labor and management,

4. Amount of unproductive or marginally productive assets and

5. Whether assets are owned or leased.

How assets are valued

You may use either a cost basis or market basis balance sheet to compare the performance of your business from year to year. Most farmers and lenders use a market value balance sheet. If you use a market value balance sheet, hold the per-unit values of your breeding stock and long-term assets (land) constant from year-to-year to eliminate the impact of simply changing asset values.

Using a cost basis balance sheet measures the performance of your farm, unaffected by market changes of asset values, as well as the return on dollars invested. However, a ROA calculated on a cost basis is difficult to compare with the ROA of other businesses using market valuation.

Because farm interest expenses are added to net farm income, rate of return on farm assets is not affected by level of debt or how debt is structured in the farm business. Thus, you can fairly compare actual business performance of both high- and low-debt operations.

Profitability of farm

Return on assets will decline during years of declining profitability. If profitability is always low, then the farm manager must look at ways to increase profitability. The ROA should be higher than the interest rate on borrowed money.

If interest rates are higher, then other parts of the business are subsidizing the interest payments for any new or existing debt. It is not unusual for other parts of the farm operation to subsidize land investments, as land typically has a low rate of return.

Level of owner withdrawals

The Ohio Farm Business Analysis program calculates the value of owner withdrawals for unpaid labor and management at $13.50/ hour, plus 5% of the value of farm production as a management charge. The ROA may be overstated if owner withdrawals are lower than this, perhaps supplemented by off-farm income.

Farms set up as corporations should calculate their labor and management charge and compare it to the salary and benefits that are already deducted from net farm income as owner/operator wages and benefits. If the calculated value of owner withdrawals is higher, the difference between the calculated and actual owner withdrawals should be deducted from the net returns before calculating return on assets.

Amount of unproductive assets

If a business has a large investment in unnecessary and/or unproductive assets, ROA may be low. In these situations, the farm manager needs to inventory these assets carefully and determine if the business could be more profitable if the dollars those assets represent were reinvested in other ways.

Are assets owned or leased?

Businesses leasing/renting the farm and/or other major assets may show a higher ROA; however, they will have higher operating expense ratios. The ROA for the high 20% of dairy farms participating in the Ohio Farm Business Analysis Program from 2011 to 2015 averaged 12.2%.

The high 10% of all farms and high 20% of herds over 300 cows averaged 14.96% and 14.3%, respectively for herds participating in the New York Farm Business Summary. The New York Farm Business Summary also deducts a charge for other unpaid labor from net farm income in addition to unpaid operator labor.

However, unless a dairy operation has large amounts of unpaid labor, this deduction will not significantly affect the resulting ROA calculation.

If you are interested in learning more about the FINPACK program, contact your local Extension office or visit https://farmprofitability.osu.edu/.