Business finance and risk
Successful rural enterprise require property owners and managers to have a sound understanding of the enterprise's financial position as well as an appreciation of what constitutes acceptable risk. This helps in the identification of potential efficiency gains, enables the business to be more robust in withstanding market and environmental fluctuations and aids the identification of opportunities to invest both within and outside the business.
Understanding business financial performance indicators can help to:
- Assess the viability of the business.
- Determine the sensitivity of the business to external factors such as interest rates and shifts in markets.
- Monitor costs of production.
- Evaluate investment options.
- Evaluate management changes.
- Investigate scenarios for improving profitability.
- Compare the business performance with forecasted performance from the business plan.
- Compare budget to actual performance.
- Compare with similar businesses.
Compliance accounting versus management accounting
When assessing the performance of the business it is important to determine why the analysis is being performed. The financial statements prepared by an accountant are designed to meet the Government's taxation compliance requirements. They are not designed to assist in measuring business performance.
Business managers are primarily concerned with the cash position of the business - what effect the business operations will have on the bank account at the end of the year and, over the longer term, the effect on net worth.
The cash position of the business can only be established through recording and reporting the income and expenditure of the business throughout the year. Taxation financial statements will not provide the required information. Effective reporting relies on good record keeping including suitable cashbook and budgeting systems.
Financial performance indicators
Many producers use an accountant, financial advisor or farm consultant to assist in monitoring and determining the financial performance or health of their business. When the enterprise's financial reports are prepared, the type of information that may be included and can help determine financial performance includes:
- Operating profit
Operating profit is also known as Earnings Before Interest and Tax (EBIT) and is the amount of cash generated by the business before the purchase or sale of capital items. As operating profit excludes the effects of financing and tax, it is often used for benchmark comparisons between businesses.
- Operating surplus/deficit
Operating surplus is the cash remaining in the business after cash costs have been deducted from the income (excluding capital). This includes direct enterprise costs and overhead costs. This figure is a direct indication of the business' operating profitability.
- Net profit
Net profit is the year-by-year indicator of the ongoing profitability of the business. Net profit is a wealth concept, not a cash concept, and includes items such as the increased value of a herd or flock and, where appropriate, takes into account asset value decline as a result of depreciation.
Equity (or net worth) equals the total value of the business less total liabilities (debts). Typically, higher equity is better, however, businesses with very strong cashflows can support lower equity levels.
- Return on total capital
Per cent return on total capital indicates how well the business has performed financially, relative to alternative uses for the same capital if invested elsewhere.
- Return on equity
Return on equity is another measure of capital use efficiency. If return on total capital exceeds percentage interest cost, return on equity will be higher than return on total capital and vice versa.
- Cost efficiency and capital efficiency
These ratios measure efficiency within the business. Cost efficiency measures total cost in relation to income and capital efficiency measures the ratio of income to the asset value used to generate it. While profit can still be achieved with high cost ratios, it exposes the business to greater risk. Ideally, the business should have strong capital efficiency and strong cost efficiency.
- Finance costs as a percentage of income
This will provide an idea of how sensitive the business is to interest rate changes. A low percentage means the business will be less affected by interest rate changes.
- Loan to value ratio
Loan to value ratio is of great importance to banks. This is the ratio of debt to the value of security.
- Interest cover
This is a measure of the earnings before interest and tax (EBIT) divided by the interest expense. It is an indicator of the business' ability to pay interest. Caution is needed as drawings are not included in the ratio and therefore the ratio often over estimates interest cover.
- Gross margin
Gross margin for a livestock enterprise is typically calculated as livestock trading account less variable costs (defined as one more animal, one more unit of cost) and is expressed per beast, per adult equivalent, per square kilometre or sometimes as a return on the value of the animals.
- Cost of production
Cost of production is a key factor affecting the profitability of livestock-producing businesses. It is measured in cents per kilogram and provides a breakdown of the costs associated with producing each kilogram of meat.
Producers should always seek professional financial advice if they are unsure how to calculate or interpret financial performance indicators or reports.
It is important to review the strategic direction and financial health of the enterprise periodically to ensure the business performance is on track and continues to operate sustainably.