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What is your level of profitability?

Tom Kriegl, University of Wisconsin Extension and Center for Dairy Profitability agricultural economist, has developed a scale to help farm families estimate how profitable their operation is, and to give them a sense of the amount of risk their farm business has — without requiring them to become economists.

“Farm families can use this scale to better understand their level of sustainability into the future,” says Kriegl. “Those finding themselves below Level 7 are urged to seek more in-depth financial analysis help.”

The profitability levels described below are numbered from 1 to 10, with 10 being the most desirable and 1 being the least desirable.

Determine the profitability, risk your farm carries

• Level 10

Level 10 is where farm income exceeds all farm costs, including the opportunity cost of unpaid labor, management and equity capital. Economists call this “economic profit.” It is rarely achieved.

• Level 9

Level 9 is where farm income exactly equals all farm costs, including the opportunity cost of labor, management and equity. Economists call this “normal profit.” Profitability levels below normal profit are not considered profitable by economists, Kriegl emphasizes.

• Level 8

Level 8 is below normal profit but is high enough for farm income to exceed farm costs, provide a comfortable level of family living and allow some increase in family savings over and above the increase in equity that occurs when loans on assets are paid. However, owners are not fully compensated for all the opportunity cost of their labor, management and equity.

• Level 7

Level 7 differs from Level 8 in that there isn’t enough farm income to increase family savings over and above farm equity increases that result from normal loan repayment.

• Level 6

Level 6 differs from Level 7 in that business expenses cannot be paid while maintaining a satisfactory standard of living unless savings or non-farm income is used.

• Level 5

Level 5 differs from Level 6 in that business expenses are paid, but family living is very restricted even if there is non-farm income. By Level 5 there are little if any savings (other than declining equity) left to fall back on. Equity can provide staying power, but can erode quickly at this and lower levels.

• Level 4

Level 4 differs from Level 5 in that despite the belt-tightening of Level 5, loans are refinanced to defer principal payments as long as possible so other bills can be paid. This can accurately be called “mortgaging the future.” (Note: Sometimes refinancing occurs at an earlier step.) Money for family living is very restricted, even if non-farm income is available. In the 1970s and early 1980s, inflating asset values allowed many family farms to regularly borrow more money despite continued low levels of profitability. At this level, options are few and chances of recovery decline rapidly. Owners should seriously consider liquidation to preserve whatever equity may remain to help the owner pursue another career.

• Level 3

Level 3 differs from Level 4 in that there is not enough money to pay even the restructured principal payments, although the family severely restricts personal expenses to pay mounting business expenses. Unpaid bills accumulate. If it hasn’t already occurred by now, most of the non-farm income is being used for the farm instead of for the family. Equity is declining very rapidly while debt is increasing with equal speed. Once again, owners should seriously consider liquidation to preserve whatever equity may remain.

• Level 2

At Level 2 there isn’t enough money to pay all current business or other expenses despite non-farm income and loan restructuring. Unpaid bills pile up with ever-increasing speed, and liquidation is imminent.

• Level 1

At Level 1 not only is income less than expense, but debts also exceed asset values, and the business ends if it hasn’t already. Many struggling businesses will end during levels 2, 3 or 4 due to overwhelming financial, emotional and/or physical stress. Salvaging as much equity as possible and transitioning out of farming is often the best strategy prior to reaching this point.

This article published in the May, 2010 edition of WISCONSIN AGRICULTURIST.

All rights reserved. Copyright Farm Progress Cos. 2010.