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Analyzing Capital Structure Enables Better Investment Decisions

20/06/2014


This article was originally published in The Western Producer.

There are several things to look for when analyzing farm profitability. Gross margin and the farm’s spending on labour, power and machinery are obvious measures, but this week I want to talk about land, building and finance (LBF), which focuses on the capital structure of the business.

Rental costs of land and buildings, interest costs and property taxes are the main drivers of this category. This analysis illuminates a farm’s net worth or investment philosophy rather than how well a farm operation is managed.

Theoretically, the analysis of a farm’s LBF costs should include a measure of opportunity cost or the imputed cost of asset rent or interest on debt used to purchase assets, even when capital is financed by the farm’s own equity.

Given that historical financial statements, which do not include this notional cost, are used in a farm’s financial analysis, LBF expenses should at least be separated from other expenses so as not to skew a comparison between two similar farm operations with different balance sheets.

To illustrate, consider a young farmer who rents 1,000 acres right next door to an older farmer who owns 1,000 acres that was paid off 20 years ago. It would not be accurate to suggest that the older farmer is managing his farm better than the younger just because he does not have any land rent.

This difference is simply a function of the difference in capital structure of the two farms. Management of these businesses should be evaluated based on the more appropriate measures of gross margin and labour power and machinery.

Consider a scenario involving two 4,000 acre farms: Farmer A owns 1,000 acres debt free and rents 3,000 acres from an investment fund. Farmer B owns all 4,000 acres, 75 percent of which is financed by a financial institution. If interest and property taxes were equal to land rent (which, presently, is close), then the farms would have essentially the same LBF cost per acre.

However, a change in the market would affect each of these investment strategies differently. If land prices continue to rise and interest rates stay low, Farmer B’s strategy would be successful. If interest rates rise and land values plateau or decrease, Farmer A’s philosophy would result in a stronger financial position.

This type of analysis does not necessarily establish which strategy is better. Rather, it reflects the impact of each strategy on the operation’s financial position and clearly separates metrics reflecting investment decisions from the operating metrics of gross margins and labour power and machinery.

Observing the LBF costs of many farms over many years has yielded a useful comparison of profitability between different types of rental arrangements.

The commonly used one third-two third gross revenue rent is a consistently unprofitable model when the rental calculation doesn’t include the associated input costs. However, including input costs results in an arrangement that is beneficial for both the landlord and the tenant.

Accurate analysis of a farm’s LBF is critical because it provides farm managers with the information that is necessary to make good investment decisions. Investment acquisition decisions (rent or purchase) must be considered carefully because they have long-term effects on a farm’s profitability.