The Rate of Return on Farm Equity

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March 15, 2024
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The rate of return on farm equity measures how many dollars you make for every dollar of equity a farm owns. It helps show how efficient a farm or ranch is when generating income.

The rate of return on farm equity is one of the key profitability ratios used in farm financial analysis.

Rate of Return on Farm Equity Formula

Rate of Return on Farm Equity = Net Income ÷ Total Equity

This article is a part of our series on Farm Financial Performance Ratios.

Description

The rate of return on farm equity (ROFE) is a financial metric used to assess the profitability of a farm operation in relation to the owner’s equity. It measures how effectively the equity capital (the owner’s investment) in the farm is being used to generate profits.

The calculation provides insights into the financial health and performance of the farm, especially from the perspective of the farm owner or shareholders.

Please note, the Rate of Return on Farm Equity is very closely correlated and analyzed with the Rate of Return on Farm Assets. Both are important efficiency ratios.

Calculating the Rate of Return on Farm Equity

In the simplest terms, the rate of return on farm equity is calculated by dividing the Net Farm Income by the Total Farm Equity owned by the farm, ranch or agribusiness operation.

Rate of Return on Farm Equity = Net Income ÷ Total Equity

To calculate this ratio, you will need to locate both Net Farm Income and the Total Equity.

Net Farm Income is the farm’s total income after expenses have been deducted.

Total Farm Equity represents the total ownership interest of the owners in relation to the assets and liabilities. In other words, this is essentially what remains once you subtract all liabilities from the assets of the company.

See the examples our examples for the general location of these two accounts in the balance sheet and income statement.

One of the challenges with this ratio is that the income statement measures performance of the farm or ranch over a period of time, where as the balance sheet measures financial metrics at a single specific point in time.

For this reason, many financial analysts, business owners and lenders take the average total assets as this helps to anchor the equation over a period of time.

Rate
of Return on Farm Equity = Net Income ÷ Average Total Equity

To get the average total assets, one must average the sum of the prior period total assets and the current period.

These two periods are typically found by taking the income statement period start date as the prior period and the income statement period end date as the current period.

Rate of Return on Farm Equity = Net Income ÷ Average Total Equity

Confused? You aren’t alone! Walk through the example below to better understand how this works.

A few final notes: sometimes interest expense is added back when measuring the rate of return on farm assets. So are wages. See below for more on when this may be the case.

Guided Example

To understand the formula, walk through the following example.

Assume that John, a farmer, has the following financial information in his balance sheet and income statement:

A 12 month period income statement ending December 31st, 2025. The income statement indicates net income of $250,000.
A balance sheet dated December 31st, 2024 with total equity of $1,000,0000. Note that the balance sheet date begins the period of the income statement, above.
A balance sheet dated December 31st, 2025 with total equity of $1,200,0000. Note that the balance sheet date is dated at the end of the period of the income statement, above.

To calculate the Rate of Return on Farm Equity, start by taking our formula:

Rate of Return on Farm Equity = Net Income ÷ ((Prior Period Total Equity + Current Period Total Equity)/2)

Then, plug in the Net Income, Prior Period Total Equity and the Current Period Total Equity .

Rate of Return on Farm Equity = $250,000 ÷ (($1,000,000 + $1,200,000)/2)

Simplified:

Rate of Return on Farm Equity = $250,000 ÷ ($1,100,000)

Using our formula, we arrive at 22.7% as the rate of return on farm equity.

22.7% = 0.22727 = $250,000 ÷ $1,100,000

What this tells us is that John is making a 22.7% return on his average total equity . This is good!

Ideal Rate of Return on Farm Equity

Just like the Rate of Return on Farm Assets, the “ideal” rate of return on farm equity (ROFE) can vary widely among farms due to differences in risk, scale, location, production methods, and individual farmer goals.

Based upon benchmarks within the agriculture industry, a good rate of return on farm equity should exceed 3%. A margin of 10% or higher puts the farmer into a strong position.

A commonly cited target for many businesses, including farms, is to achieve a rate of return that exceeds the cost of capital. The cost of capital includes the interest rate on borrowed funds and the expected return on equity capital. For example, if the overall cost of capital for a farm is around 5%, the farmer would aim for a rate of return on farm assets above this level to ensure the farm is not only covering its costs but also generating profit.

Here are some general targets:

Low-Risk Operations: Farms with lower risk, possibly due to diversified income sources, strong demand for their products, or lower operating costs, might be satisfied with a lower rate of return, perhaps in the 3-5% range, because their risk-adjusted return is favorable compared to other investments.

Higher-Risk Operations: Farms in higher-risk categories, such as those dependent on volatile commodity prices or those in areas prone to adverse weather conditions, might aim for higher rates of return, potentially 5-12% or more, to justify the increased risk.

Growth Stage: The stage of the farm’s business cycle can also impact the target rate of return. New or expanding farms might accept lower initial returns or even operate at a loss as they invest in growth, while established farms might seek higher returns as a reflection of their stability and maturity.

Over a period of time, it has been shown that a good rate of return on farm equity should be in the range of 3% or more, with exceptionally run farm operations generating rates of return of 10% or greater.

How to Improve your Rate of Return on Farm Equity

Improving the rate of return on equity (ROFE) in farming involves enhancing the efficiency with which equity are used to generate income. Improving the return on farm equity (ROFE) involves strategies aimed at increasing profitability, managing costs, and optimizing the use of equity capital.

Here are several strategies farmers can employ to improve their ROFE:

Increase Revenue

There are a multitude of approaches a farm or rancher can use to improve revenue. Each strategy is different, however, here are some of the strategies to consider.

Diversify Production. Introducing new crops or livestock can open additional revenue streams, reduce risk associated with market fluctuations, and make better use of existing assets
Improve Product Quality. Higher quality products can often be sold for a higher price, improving income.
Adopt Advanced Technologies. Precision agriculture, automation, and other technological advancements can increase yield and product quality.
Market Directly to Consumers. Direct sales through farmers’ markets, CSA programs (Community Supported Agriculture), or online platforms can increase profit margins by bypassing intermediaries.
Value-added Products. Transforming raw agricultural products into processed goods (e.g., cheese from milk, jam from fruits) can significantly increase their value and market appeal.

Reduce Expenses

Similar to improving revenue, there are also a multitude of approaches a farm or rancher can use to decrease expenses. Remember, however, that some expenses are well worth the eventual revenue those expenses generate. Be careful not to cut costs to far!

Efficient Use of Inputs: Optimizing the use of seeds, fertilizers, water, and energy can reduce costs while maintaining or even increasing yields.
Control Labor Costs: Automating processes and efficiently managing labor can help control one of the most significant farm expenses.
Lease Underutilized Assets: Leasing out land or equipment that is not fully utilized can turn dormant assets into income sources.
Reduce Waste: Implementing practices to reduce waste can save costs on inputs and improve overall efficiency.
Bulk Purchasing: Buying inputs in bulk or collaborating with other farmers to purchase supplies can lead to significant savings.

Asset Management & Financial Management

Asset management and financial management ultimately help the farmer to better position and maintain those assets and liabilities they can control. A few key things to keep in mind:

Refinance Debt: Lowering interest rates on existing debt through refinancing can reduce financial costs and improve net income.
Invest in High-Return Projects: Focus on investments within the farm that offer the highest potential returns on equity.
Government Programs and Grants: Taking advantage of government subsidies, grants, or tax incentives can provide financial benefits and support specific improvements or initiatives.
Reinvest Profits: Carefully consider the reinvestment of profits to grow equity and improve the farm’s asset base.
Owner Withdrawals: Manage personal withdrawals from the business to ensure that they do not adversely affect the farm’s capital structure and growth potential.

How the Rate of Return on Farm Equity is Used

The rate of return on farm equity is a crucial financial metric used by agricultural businesses, as well as businesses across various industries, to assess their efficiency and financial health. Below are a few key areas where the impact of Return on Farm Equity is Most Impactful.

Performance Evaluation

It provides an indicator of how effectively the equity invested in the farm is generating income. A higher ROFE suggests efficient use of equity capital.

Decision Making

Farmers and farm managers use this metric to make informed decisions about expanding, diversifying, or downsizing their operations. It can guide investments in new technologies, land, or equipment by showing the potential return on these investments.

Benchmarking

Comparing the farm’s ROFE with industry averages or similar farms provides a benchmark for evaluating performance and identifying areas for improvement.

Securing Financing

Financial institutions may evaluate the rate of return on farm equity when farmers apply for loans or credit lines. A healthy rate of return indicates a profitable operation, which can lead to more favorable loan terms or interest rates.

Investor Analysis

For farm owners and potential investors, ROFE is a critical metric for making investment decisions. It helps in assessing whether the farm offers a satisfactory return on equity compared to other investment opportunities.

Strategic Planning

Understanding the return on equity can guide financial planning and strategy, including decisions about borrowing, reinvestment, and capital structure adjustments to optimize financial performance.

Risk Management

Analyzing the rate of return alongside other financial metrics can help farmers understand their risk exposure. For instance, a farm heavily reliant on borrowed capital might see significant fluctuations in its rate of return due to interest rate changes or economic downturns.

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