Operating expense ratio: Protect profitability and your financial fitness
What a difference time makes. Borrowing costs climbed in 2018 from their historic lows one year earlier. Farm cash receipts flattened nationally over the same period. Throughout March, FCC Ag Economics will make sense of these evolving financials and more. Check back weekly to see where Canadian ag is going – and how key financial tools can help you stay ahead of the game.
Rising farm input costs or declining commodity prices may well pressure profit margins this year. As that happens, I recommend farm operations focus on efficiency, a task made easier by using the operating expense ratio (OER).
Operating expense ratio
The operating expense ratio measures an operation’s variable costs relative to that operation’s gross revenue.
OER = Total operating expenses / Gross revenue
Variable costs include daily operational expenses (labour, feed, crop protection, fuel, maintenance, insurance, repairs, and ag specialist fees, for example). Loan payments, depreciation, and capital improvements are excluded from operating expenses.
How it works
An OER of 60% indicates an operation spends 60% of its revenues on variable expenses. If an OER is too high, a farm may have higher expenses than it can be expected to cover with revenue. Possibly exposing a producer to financial challenges if market conditions worsen, an overly high OER also reduces the income available to cover fixed costs or build equity.
A note of caution
Neither the profitability nor the OERs for different sectors are directly comparable, because each OER reflects sector-specific patterns in costs and revenues. Instead, watch historical trends.
Rising input costs in all sectors, again
Growing expenses will pressure Canadian ag profitability in 2019. It was tested in 2018, with the year’s turbulence hitting some markets harder than others. Price volatility arising from trade disputes took a bite out of hog margins, while dairy prices improved over the second half of the year. Everyone, however, faced rising farm input costs.
I expect those costs to rise again in 2019, enough to apply continued pressure to sector profitability. The OER is one of the best ways to understand and manage a sector’s fluid relationship between operating expenses and revenues.
Average OER tells of sector profitability
With a looming possibility of pressured OERs in 2019, here’s a look at each ratio’s most recent history. Figure 1 shows how varying patterns in revenues and costs have produced differences in the average OER for dairy, hogs, cattle, and grains and oilseeds farms*.
Figure 1: Dairy sector shows stability in average revenue-expenses spread
Source: FCC portfolio data
Of the four, the grain and oilseed sector’s OER saw the most consistent improvement between 2013 and 2017. Producers benefitted from strong growth in revenues over that period while enjoying smaller increases in crop input prices. Both cattle and hog producers dealt with more volatile revenues during this period and as a result, the OER for those sectors fluctuated more broadly.
Efficiencies help dairy survive depressed prices
Dairy gross revenues climbed 8.1% between 2014 and 2017, despite a growing surplus of solids-non-fat and the declining price of skim milk products. The sector’s revenue growth was buoyed instead by strong production growth.
Growing production required more inputs which, in turn, could have increased variable expenses. The sector’s OER was stable, however. The top 50% of Canadian dairy producers spent no more than $0.67 on operating expenses for every $1.00 in revenue each year.
Dairy’s stable OER tells a great story. As their costs increased in tandem with increased production, Canadian dairy farms introduced efficiency measures to ensure the proportion of variable resources used to earn a dollar of revenue stayed the same.
What does the future hold?
In periods when expenses grow more quickly than income, the OER is likely to increase, suggesting a declining profitability. That can become a bigger problem when it continues over several years. Efficiency measures - minimizing production costs using the right mix of farm inputs – are among the best tools producers can use to manage profitability in 2019.
The OER should be used in conjunction with other ratios to properly assess overall financial health. Work with your lender and accountant to determine the suggested ratios for your specific industry and be sure to understand them according to your own strategy and the risks facing your own operation.
* This analysis is based on data from FCC’s portfolio (2013 – 2017).
Are you comfortable using financial statements to better manage your operation? A good place to start is your accountant or an FCC Relationship Manager.
J.P. is the Vice-President and Chief Agricultural Economist at Farm Credit Canada. Prior to joining FCC in 2010, J.P. was a professor of agricultural economics at North Carolina State University and Laval University. He also held the Canada Research Chair in Agri-Industries and International Trade at Laval. J.P. is Past-President of the Canadian Agricultural Economics Society. He obtained his PhD in economics from Iowa State University in 1999.