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Making and managing profits

Definition of profit

Profit is typically referred to as the financial gain measured annually. Financial profit can be summarised as the difference between the amount earned (income) and the amount spent (costs).

Profit = Yield * Price – Costs.

Financial gain as defined above is one measure of success. Other important drivers of business success can be:
• Equity growth (financial).
• Lifestyle and family (people).
• Health and wellbeing (people).
• Resource sustainability (environment).

Financial profit can be measured as taxable income or cashflow surplus.

Taxable income is calculated by your accountant and is listed within the profit and loss (P&L) section of your financial statements. The P&L doesn’t include non-deducted expenses such as capital purchases, principal repayments on debt and personal/family living costs.

When benchmarking a business’s performance, profit measured as cashflow surplus is the preferred measure. The cashflow surplus can be monitored as the annual change in the bank trading account.

In both definitions of profit an inventory and family allowance adjustment is needed if measuring the annual profit or loss for management purposes.

Range in profits

Comparison of average and Top 20% farm figures
Costs and cash surplus for the ‘Average’ SA farm business and the ‘Top 20%’ SA farm business are provided in Figure 1 and Figure 2.

 MakingManagingProfitsFig1

Figure 1. Costs and cash surplus for Average SA farm businesses (Source: AgProfit™, dataset = 56).

 MakingManagingProfitsFig2

Figure 2. Costs and cash surplus for Top 20% SA farm businesses (Source: AgProfit™).

The Top 20% group generated approx. 2.5 times the surplus to that of the Average farm.

The 5 year average income for this group of SA businesses was $723,000. The Top 20% group achieved profits of 13% (22% less 9%) more than the Average group. Over 5 years this results in an extra $470,000 available as cashflow surplus (profit).

Profit drivers

Profit drivers are commonly identified as:
1. Farming System/enterprise mix.
2. Costs.
3. Income volatility across years.
4. Management / decision making.
5. Efficiency / timeliness.

Things that do not drive profit are:
• Location.
• Scale.
• The newest and best machinery.

Return on capital and capital growth

Capital growth in land can occur in addition to profit (loss).

Return on Capital (RoC) is another way of expressing profit and is calculated by profit/asset. When profit (RoC) and capital growth are combined then the return from investing and farming rural land is very competitive with other investment options.

A report by Rural Bank on capital growth in land values across Australia shows that over the last 20 years the average annual growth in SA land values has been 5.8% (See detailed report at: Rural Bank website).

Consequently, in SA the Top 20% typically achieve 8 to 12% RoC plus capital growth in land of 5.8%.

Spending the profits

Making a profit is hard enough; the next step is to determine what to do with the profits generated.

How individuals spend their profits can be summarised into four main areas:

  • Profits reinvested into business (into cashflow):
    o Increase scale through land lease or sharefarm.
    o Infrastructure such as shedding, water supply.
    o Productivity improvements such as soil amelioration (liming/claying/fertiliser).
    o Efficiency gains such as auto steer.
    o Machinery / technology.
  • Profits invested for business growth:
    o Debt reduction.
    o Capital acquisition such as land purchase.
    o Capital enhancement such as increased investment in machinery.
  • Financial buffers:
    o Farm management deposit (FMDs).
    o Insurance premiums for succession planning.
    o Superannuation.
    o Off-farm investments; real-estate or shares.
  • Lifestyle

Business life cycle

Equity ($) growth over time provides a guide to the life cycle stage of a business. The stages of growth have different priorities for profit allocation and performance benchmarks. The run of seasons and family support are key contributors to successful outcomes and the time it takes to move through the business life cycle.

Figure 3 represents the business life cycle, a cycle which typically takes a generation (25 years) to complete.

 MakingManagingProfitsFig3

Figure 3. The business life cycle.

Business viability

Key measures of financial viability are profit for debt servicing and asset availability as security.

Measures of business viability are listed in Table 1.

Table 1. Measures of business viability

 MakingManagingProfitsTable1

Succession planning

As mentioned earlier scale is not a driver of profit, however there is a minimum level needed for a family to be working fulltime on-farm.

The benchmarks listed in Table 1 can provide an indication of scale for an ‘emerging/growing’ farming family.

If the family goal is to have $115,000 available for living, schooling, tax and debt repayment, then the benchmarks outlined in Table 1 can be applied to determine the asset value required to sustain a fulltime on-farm family unit (Table 2).

Assumptions

  1. Surplus is 8% of income
  2. Costs as % of income are:
    a. Overheads (rates, insurance, prof. fees) 8%
    b. Farm Inputs (Fertiliser and sprays, seed, etc.) 30%
    c. Machinery (fuel, repairs, contracting, capital replacement) 28%
    d. Finance (interest, bank fees and rent) 11%
    e. Labour (own living, school casual employees) 15%
  3. Income is 15% of current asset value (land and machinery).
  4. Machinery value equals income.
  5. Land current market value is $4,000 per hectare.
  6. Crop income per hectare is $800 per hectare (wheat yield of 4 ton/ha).
  7. Crop intensity 80%.

Table 2. Determination of scale for an ‘emerging/growing’ farming family.

 MakingManagingProfitsTable2

The scenario detailed in Table 2 can assist when setting goals for generational transfer or for business growth to include additional labour units.

Conclusion

Financial benchmarks provide support for business managers when planning enterprise mix, crop inputs and business investment. They are a measure of business performance which can be used to assist with goal setting for the future direction of the business and family.

Each business will have a different combination of benchmarks, however the net outcome measured as profit can be similar.

Contact details

Phil O’Callaghan
46 Edward Street, Bendigo, Vic
This email address is being protected from spambots. You need JavaScript enabled to view it.
03 5441 6176
@Phil_OCallaghan