Objectives • Understanding determinates of operating performance (ROA) • Understanding determinates of financial performance (ROE) • Links between managerial decisions and financial performance
Operating Profit Margin Turnover Ratio Return on Assets X = Determinants of Operating Performance (ROA) • Operating profit margin • Asset turnover ratio
Return on Assets InterestAssets Leverage ROE - X = Determinants of Financial Performance (ROE) • Operating profit margin • Asset turnover ratio • Leverage
Profitability Analysis AKA The DuPont Model
Gross Revenue Fixed Costs Variable Costs Net Income - - = Operating Profit Margin Net Income Interest Expense Gross Revenue + ÷ = - Interest Assets ROA x Gross Revenue ÷ Turnover Ratio Total Assets = ROE x Financial Structure Total Assets Equity Financial Structure ÷ = DuPont Analysis Operating Performance
Implications • If ROE > ROA • Interest rate less than ROA • Making money on borrowed money • Increase ROE by borrowing more (but be careful)
Implications • If ROE < ROA • ROA less than interest rate • Losing money on borrowed money • Reduce interest cost • Reduce debt • Improve operating performance (ROA)
Improving performance • Ways to enhance operating performance (ROA) • Increase operating profit margin • Increase volume per dollar invested or capital turnover • Ways to enhance equity return (ROE) • Enhance operating performance • Reduce financing costs • Leverage – more debt
Income Statement Balance Sheet Data for Profit Analysis • Gross Revenue • Fixed Costs • Variable Costs • Interest Costs • Total Assets • Equity
Example Case: MBC Farms • Operated by Mike, Betty, and Craig • Enterprises • Crops, dairy • Operate 3,000 acres, 250 milking cows • Own 1,800 acres, cash rent remainder • Six full-time employees
Worksheet 4 Spreadsheet for MBC Farms Case
Reduced interest • Opportunity to refinance term debt at a 1% lower interest rate • $91,648 in intermediate debt and $799,573 term • Saves about $8,913
Earlier soybean planting • Has been planting about half of soybeans after June 23 • Pushing harder would result in about a 10% increase in soybean revenue • No change in costs
Summary • Measurement of performance • Operating: ROA • Financial: ROE • Determinants of rates of return • Operating profit margin • Asset turnover ratio • Cost of debt • Leverage • Links among managerial decisions & rates of return
Key Points? • What are the 2 key elements of operating performance? • Overall financial performance is measured by what ratio? • With respect to financial performance, when is debt a good thing?
References • Boehlje, Michael, Craig Dobbins, Alan Miller, Dawn Miller, & Freddie Barnard, Measuring and Analyzing Farm Financial Performance, Department of Agricultural Economics, Purdue University, EC-712, 1999 (pages 37-43), • Miller, Alan, Michael Boehlje, and Craig Dobbins, Key Financial Performance Measures for Farm General Managers, Department of Agricultural Economics, Purdue University, ID-243, June 2001.