There are a lot of ways to measure the financial health of your business. In times when margins are tight, the operating expense ratio is one that can paint an accurate picture of not only how your business is performing, but what adjustments can be made to operating and input costs.
The operating expense ratio is a measure of your operation’s financial efficiency and shows how much you spend to generate income. It takes into account both the production and income side, as well as the expense side, to paint a clear picture of your operation’s efficiency. Expressed as a percentage, the operating expense ratio is your total operating expense (excluding interest), minus depreciation, divided by gross income.
Why it’s important
The normal operating expense ratio range is typically between 60% to 80%, and the lower it is, the better. “Below 70%, you’re doing a really good job of controlling expenses,” says Vice President AgDirect Credit Jerry Auel. “If you are between 70% and 75%, you’re probably doing okay, but if you start getting above 75%, you’re trending toward being a high-cost producer.”
Why is your operating expense ratio important? When approaching a lender for financing, this ratio is one way to show your operation’s financial stability and can influence how much it will cost you to borrow money to sustain your operation.
“It’s important for producers to pay attention to it because you can’t maximize efficiency if you don’t know how you’re controlling expenses,” says Auel. “Once you know where your costs are, you not only can control them better, but make better marketing decisions.”
What to do if it’s too high
If you do find yourself with a higher operating expense ratio, it should signal action to improve your operation’s cost efficiency. Auel recommends looking at both variable and fixed costs. For example, land costs may have a big impact on your operating expense ratio, especially in the context of today’s low grain prices.
“Land cost is something you have the ability to manage. If you’re in a high cash rent situation, that can really hurt your operating expense ratio – especially with the price of corn at around $3.60/bushel,” Auel says. “All of a sudden, that price means your land costs are a higher percentage of expenses compared to what your income has been over the past few years with $5-$7 corn. Maybe that means renegotiating cash rents, or giving up high cash rents altogether and finding lower-cost land.”
The same applies to lower operating purchases on your operation; maximizing cost efficiency on inputs like seed and fuel can help get your operating expense ratio back into the optimal range.
“Now more than ever, you need to be as efficient as possible with seed, fertilizer and fuel because we’re sitting at $3.60/bushel corn and chances are, breakevens are closer to $4.00/bushel or more,” Auel says. “Focusing on bringing those costs down and improving your ratio should be a priority.”
“Keep good records so you can look back and see where you can cut costs. If you think you’re buying smart, you need to really keep track and know what may be holding you back. If you don’t know what your expenses are, you don’t know how to maximize your profitability.”
That may mean a shift toward more proactive planning for expenses. If you’re facing high land rent, for example, start negotiating with your landowner earlier in the year. If you’re looking to trim input costs, watch for discounts that are typically offered earlier in the traditional decision-making process.
“The time to control costs is in the September-to-March timeframe. Give notification to your landlord. Seed companies offer discounts if you pay early. If you can take advantage of discounts like that, it may be a good thing to do early,” Auel says.
The lender’s view
If you do pay 2016 expenses this year, your total operating expense ratio will likely take a hit in 2015 – your income statement for this calendar year will show a disproportionately high expense figure. If that is the case, don’t worry; lenders typically look at the ratio on a year-over-year basis. That means if your expenses are high because you’ve prepaid to capture discounts on things like seed and fuel, you won’t lose financing flexibility because of those increased expenses.
“We look at it on an annualized basis. In 2015, if somebody’s prepaying for expenses for 2016 and maybe didn’t prepay for this year in 2014, their operating expense ratio will balance out,” Auel says. “Chances are if you’re paying for 2016 expenses now in 2015, your 2016 expenses are going to be lower for the 2016 calendar year. As a lender, we average it out.”
And, the income side also influences the operating expense ratio; prepaying for the next year’s expenses – and the tax implications of doing so -- can be offset by selling grain before the year’s end, but it’s best to consult your tax professional before executing that strategy, Auel says.
“Producers also consult with their tax accountant, which is the right thing to do, to decide when to pre-pay expenses and when is a better decision to sell grain from a tax standpoint,” he says. “For instance, if the accountant says wait till 2016 to sell your 2015 crop, that will also impact your operating expense ratio.”