When someone mentions that a business is “profitable,” people assume they know what that means. However, we shouldn’t casually make this sort of judgment call. This topic comes to the forefront after reading the item “A few dairy farmers are still making money” in the October 15, 2018, edition of Hoard’s Dairyman Intel.

To calculate profitability, we require several key financial documents, including: the operation’s annual balance sheet, income statement (also known as a Profit & Loss), total farm assets, farm owner’s equity, and net farm income. We can use those numbers to calculate the Rate of Return on Assets and Rate of Return on Equity.

An operation is legitimately profitable if its Rate of Return on Assets is higher than the interest rate being paid on farm loans. Its Rate of Return on Equity would also be higher than the Rate of Return on Assets.

When we calculate profitability, we’re determining if the farm is a wise investment. Is the net value of the operation’s production each year enough to justify tying up the owner’s equity or taking on debt to finance farm assets?

When we say a farm is “profitable,” perhaps what we really mean is that the operation generates an adequate amount of cash flow to continue into the future. Adequate cash flow allows the coverage of all operating expenses, family living costs, income tax and Social Security payments, loan payments, replacing equipment, and still have cash left to put into reserves. Cash flow doesn’t tell us if the farm is a good investment, it just tells us if it can sustain itself.

Why worry about the difference between “cash flow” and “profitability?”

Because it’s not uncommon to have positive cash flow and yet be unprofitable. We see this with operations that have been in business for a long time. Loans have been paid off, family living costs are low, and asset values have gone up, as has the farmer’s equity. Cash flow is fine, but the rates of return on assets and equity are both low. This is a terminal condition. It can sustain itself but nobody could purchase the farm at its market value and survive by operating it as is.

The opposite can also be true.

Some farms may be profitable yet have poor cash flow. They are building inventories, which factors into net farm income and profitability, yet cash income might be low. They might be making loan payments but can’t cover family living costs, replace assets that wear out, or put anything into savings. This is an acute condition. An operation can’t survive long with poor cash flow. Things need to change quickly.

Cash flow and profitability need to be evaluated separately. An operation needs both to survive and thrive from one generation to the next.

For additional insights from Paul Dietmann and the rest of the Compeer Financial team, visit Compeer.com.