A few weeks ago, DEFRA published its initial analysis of farming’s financial performance for England in 2015/16. As ever, there are statistics to suit everybody’s needs. What caught our eye was the Return on Capital Employed (‘ROCE’ pronounced so it rhymes with croquet).
ROCE should provide a balanced measure, as it assesses how efficiently capital is used to generate profit, thus allowing a comparison across farms of different size. Defra’s calculation divides operating profit (Farm Business Income minus an estimate of unpaid labour) by total assets minus current liabilities. This means a higher ROCE is achieved by either having a large operating profit relative to the assets held by the farm, or by having a small capital employed base. A low ROCE is generated where a farm has low profits and/or has a large amount capital employed relative to profits.
However, if you own your land, the calculation may show a lower percentage return than tenanted land (due to more assets); if you have an overdraft (a current liability) rather than a long-term loan, your capital base is smaller and the return percentage higher; if the value of your land has risen, your percentage ROCE falls due to the larger denominator. There is a wide range of values across farms, with Defra reporting the median ROCE falling to -0.7%, from a peak of 1.6% in 2011/12, with only positive returns from general cropping at 0.3% and cereal at 0.1%. Interestingly, if the land value for pig and poultry farms is stripped out, their mean ROCE increases from 2.7% to 6.9%.
This surprised us, as logically a negative ROCE implies all farmers would be better off selling up and putting their capital elsewhere, or that there’s no economic sense in entering farming. Clearly the real world tells a different story, which suggests the statistics might be awry.
ROCE is a well known metric in the financial world where it is used relative to a cost of capital and adjustments to accounting values to reflect market values. No such luck with DEFRA’s numbers, at least until you go behind the press release and read the footnotes to their analysis. For example, they reported larger farms tended to have a greater ROCE than smaller farms (unsurprising), and almost all high performing farms had a positive ROCE. However, 72% of tenanted farms had a negative ROCE, but tenanted farms were also more likely to have a return on capital of over 10% compared to other types. Conversely, the median ROCE for dairy farms was negative for the first time since 2009/10, after having the highest median return for the two previous years. As we all know the trajectory of the milk price has started to turn upwards after several years of downward travel, this seems peculiar.
For the non-accountants, it’s worth remembering that although FBI equates to accounting operating profit, they do differ, as operating profit is based on accounting standards, while FBI uses management accounting. For example, financial accounting stock is valued at the cost of production, while management accounting uses market price.
So what do we take from this? We found three quotes that might help and which reinforce our approach to lending, which is there is no substitute for being out on the ground and dealing directly with people, rather than sitting in the office asking the computer . . . . . .
- Get your facts first, and then you can distort them as much as you please (Mark Twain)
- If your experiment needs statistics, then you ought to have done a better experiment (Ernest Rutherford)
- Statistics are no substitute for judgement (Henry Clay)