While net income per cow and net income per hundredweight of milk produced are good measures of profitability, they don’t go far enough to truly compare the overall financial performance of an operation.
For example, these measures do not tell us whether a farm is profitable because it is efficient in utilizing assets, or if it is because it doesn't have any debt. In order to determine if a dairy’s profitability is the result of good management and high efficiency, you have to look deeper.
Consider this example. Two farms are identical in terms of cow numbers, assets, labor cost, and all other production factors. Each farm’s balance sheet and income statement data are shown at right.
Of the two farms, Farm A has a net income per cow of $320, while Farm B earns $220 per cow. On the surface, it appears that Farm A is more successful. However, if we perform a DuPont Analysis of performance and compute the various financial ratios that account for the differences in the equity positions of the farms being compared, we will find the real answer.
Turnover ratio is a measure of productivity. It reflects the total income per investment in assets. The higher turnover ratio for Farm B in Table 2 indicates that it generated more income than Farm A from the same investment in assets.
Profit margin measures efficiency. It shows the percentage of total income that is returned to assets. Table 2 shows Farm B captures a greater percentage of sales as returns to assets than Farm A. Assuming both farms receive the same milk price, Farm B’s higher profit margin means that its average cost of producing milk is lower than Farm A’s.
Return on assets measures the rate of return on farm assets. Given Farm B’s greater production and higher efficiency, we know that the owner does a better job of utilizing assets, managing production, and controlling costs. The result is a higher return on assets — 9 percent for Farm B vs. 8 percent for Farm A.
Return on equity measures the level of return for each $1 of owner equity invested. The higher the value of this ratio, the better as it means greater profits. Once again, Farm B leads the way with an ROE of 11 percent vs. 8 percent for Farm A.
Together, these four ratios provide a meaningful measure of a dairy farm’s success in managing assets and generating returns with a given stock of equity capital. It’s time to make them the standard for comparison in the dairy industry. To get an accurate measure of financial performance, we must move beyond net income per cow.
Bruce Jones is the director of the Center for Dairy Profitability at the University of Wisconsin.