Sheep Health & Production

Introduction | Some basic accounting - Financial statements | Financial performance of typical sheep farms | Economic analysis of enterprises and strategies | Recommended reading

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Introduction

The following discussion is intended for the veterinarian who works as a rural practitioner servicing the grazing industries. The objective is to explain the economic structure of farm businesses so that advice given by the veterinarian is appropriate to both the financial position and the profit-making aims of the client. Advice which is economically inappropriate is unlikely to be adopted or, worse, may be adopted and contribute to a deteriorating financial situation. When veterinarians offer advice which includes a proper economic assessment, their credibility is enhanced and the client benefits from sound advice.

Advice is appropriate to a client' s financial position if the cost of its implementation is feasible for the farm business without significantly increasing the risk of business failure. For example, following the diagnosis of footrot on a client' s property, he may be correctly advised that the disease is sufficiently serious to warrant eradication. It may be that the same client is in a tenuous financial position with limited ability to fund any further capital expenditure or employ further labour. The lack of funds will reduce the chance of a successful eradication campaign; the extra expenditure may push the farm business over the brink of viability. It is of little solace to a producer to have achieved eradication of footrot after three years if the farm is no longer in his ownership. In such a case, appropriate advice would be to establish effective, cheap control measures which limit the effect of the disease while an appropriately trained adviser addresses the immediate financial problems which the producer faces.

Advice is appropriate to the profit-making aims of a client if the net financial benefit which arises from implementing the advice increases profit or decreases the risk of loss. Such advice is not always easy to give, for it demands a proper appreciation of the whole farm system, not just the isolated component currently under investigation. For example, assume a client' s spring-born Merino weaners are dying during the summer from malnutrition compounded by parasite burdens. Advice that he should lamb earlier in the year to ensure the weaners are better grown before summer is, in fact, correct but it is not the most appropriate advice that can be given. An earlier lambing will substantially decrease the performance of the ewes and the client, if he took the advice, might lose more money from the poorer productivity of the ewes than he gains in better weaner health. More appropriately, the producer could be advised to institute hand-feeding earlier and base parasite control on regular faecal egg count monitoring.

Interestingly, producers are often not surprised to receive inappropriate veterinary advice and may accept it without argument. Fortunately, they do not implement it either, but decide that either they are poor managers or that the problem has no solution. Many resources, both of the veterinarian and his or her training, and of the producer, are wasted as a consequence.

So how should veterinarians cope with this problem? First, it is important to understand the basic financial structure of farm businesses. This means having an appreciation of the economic operation of farms in general, even if information about the specific client is unavailable. Second, one needs to understand the effects that particular management strategies have on the profitability of those businesses. Third, it is often best to offer a range of options when advising clients, particularly if doing so without privileged insights into the client' s financial affairs.

Some basic accounting - Financial statements

It is possible to gain considerable insights into the soundness and profitability of a business by examining its financial statements. Two of the most useful and familiar statements for this purpose are the Balance Sheet and the Profit and Loss Statement.

Balance sheet

The Balance Sheet is a list of the assets and the liabilities of the business. An asset is an item which is of value to the business - which could be sold and realise cash. Assets usually enable the business to produce income or, in the case of cash, allow the purchase of income-producing items. Assets include buildings, tractors, livestock and cash in the bank. Assets can also include debts owed to the business. In veterinary practice, for example, clients who do not pay for veterinary services immediately but delay payment for some days or weeks, are known as debtors of the business and constitute an asset of the business.

Liabilities are debts owed by the business. In most businesses loans to the business constitute the major liabilities, and these loans are usually made by banks or private individuals. These lenders are known as creditors of the business. In veterinary practice, suppliers of pharmaceuticals to the practice usually wait up to 30 days (or more!) for payment. After they have supplied the goods and while they await payment, they are creditors of the business.

In accountancy terms, the business owns the assets rather than the proprietor. The proprietor is one of the creditors or suppliers of funds to the business - along with the bank, the stock firm, relatives or anyone who has lent money to the business. The liability of the business to the proprietor has a special name - equity, or owner' s equity. It represents the capital funds introduced to the business when the proprietor started it and so is often referred to on Balance Sheets as the owner' s capital account. Equity is the owner' s investment in the farm business.

By definition, on a Balance Sheet:

The Balance Sheet, therefore, is always in balance! The top part of the Balance Sheet (Table 2.1) lists and totals the assets of the business; the second part lists and totals the liabilities and the owner' s equity. The two totals will always be equal.

The Balance Sheet demonstrates how much money the owners could realise if they sold all the assets and paid all the debts. It shows, therefore, the financial position of the owners in relation to the business at any one point in time. It does not reflect the profitability of the business although inferences could be made (with knowledge of the likely productivity of their particular enterprise) about the viability of the business. The farm business is viable if it has the ability to service (pay interest on) its debts and still have some money left over to provide the farm family with living expenses. If it does not have that ability, its debts will increase and the owner' s equity will decline.

Table 2.1: Balance sheet for sheep farm business

Table 2.2: Profit and Loss Statement for sheep farm business

A simple Balance Sheet is illustrated in Table 2.1. The farm business had, at July 2000, assets worth $1.23m. Another way to say this is that 'the farm is worth $1.23m'. The farm business has liabilities of $61,000 in two loans - one from a relative, perhaps one whose share in the farm was purchased by the present proprietors but who was not paid in full, preferring to be paid interest by the farm business. The other 'loan' is an overdrawn cheque account at the bank.

By definition, the remainder of the value of the farm business belongs to the two proprietors of the business - the farm owners. If the farm assets are truly valued at current market values then the farm could be sold, all debts ($61,000) paid, and the proprietors would keep the rest of the proceeds. This amount ($1,169,000) is their equity in the business. Equity is sometimes expressed as a percentage of the total assets. These proprietors have 1,169,000/1,230,000 x 100 = 95% equity in their farm.

Although it is not shown on the Balance Sheet, we can expect that the business has to pay interest on its debts. The level of indebtedness will vary through the year but, if $61,000 were the average debt, the interest bill might be around $6,000 to $8,000 per annum, depending on the interest rate. This amount of interest will show on the Profit and Loss Statement, because interest is one of the expenses of the business. On some farms, equity is very low and farm debts are very high. In such cases the interest bill may be so high as to cripple the business - because it cannot generate enough income to pay the interest. Such businesses are not viable.

Profit and Loss Statement

The Profit and Loss Statement reveals the revenue earned and the expenses incurred in the operation of the farm business over a defined period - usually (at least a part of) a financial year. Revenue earned on-farm normally comes from the sale of produce (wool, meat, livestock, milk, grain etc) and expenses are those monies spent on products completely consumed in the production process (shearing labour, drench, fuel etc) rather than on assets with much longer life (buildings, tractors etc) or family expenses unrelated to the farm production (clothes, groceries for the immediate family, school fees, fuel for the Fairmont sedan etc). In Table 2.2 the Profit and Loss (P & L) Statement shows that the farm business made a profit in the 12 months to June 30, 2001 of $40,500. There are several important points to notice in this statement.

Different types of expense account

Each line in the statements relate to one item or account. The expense accounts in the P & L Statement can be classified into several categories. Payment of interest, for example, is a financial expense. A major distinction exists between variable and fixed expenses. The difference between these two categories is important in some forms of farm financial analyses, which will be discussed shortly. Variable expenses are those which vary with the size or intensity of the enterprise. Note in the example shown, the first seven expense accounts. If there were no sheep on the farm, these would have zero balances; ie, nothing would be spent on shearing, animal health etc. These are examples of variable expenses - they are bigger when the enterprise has more sheep. Fixed costs would not vary; for example, administrative costs, rates and taxes, fence insurance etc. These costs are fixed - they exist whether the paddocks are stocked, cropped or empty.

Owner's labour

On this farm, the owners have supplied the main portion of the labour and management of the farm. $40,500, therefore, represents the return on their equity (which is cash they have invested in the farm) and their management (and labour). Presumably, if they paid themselves a proper' wage' the business would have made a loss and the return on equity would have been negative. Being owners, funds which they use to spend on personal items are termed drawings.

Depreciation

Depreciation of the value of some assets is an expense of the farm business but is not a cash expense. It is an expense on paper only. It is fair, and good business practice, to account for the decline in value of farm assets like tractors, shearing plant etc, and this allowance for depreciation is deductible from taxable income. Nevertheless, the net farm cash income is actually $6,000 higher than the profit shown.

Wool income versus livestock sales

92% of the total income from sheep products was derived from the sale of wool, 8% from the sale of livestock. This ratio of about 9:1 is typical of most commercial Merino sheep farms. In 1992-93, on average across all Australian sheep farms, 80% of sheep income was derived from sale of wool, 20% from sale of livestock _[1]. The fact that a high proportion of income is derived from wool has implications for many management and veterinary strategies on sheep farms.

Cash flow

The business both received interest as income and paid interest as an expense. This fact reveals an important characteristic of cash flow on sheep farms. Income is largely derived at one or two shearing events each year. When wool is sold, some short-term debts (such as bank overdrafts) are paid, surplus cash invested in term deposits (say, 3 to 6 months) and the farm business receives some interest from the investment. Core debt, such as farm mortgages are not repaid because the cash in short-term investments will be required for operating funds during the year. By the time shearing comes around again, cash is often in short supply and the business may be operating with bank overdrafts again. One can see that, if farm debt was high, interest expenses could be so high that the interest bill would exceed the profit. When that happens, unless remedial action is taken, additional funds must be borrowed every year. The farm business can then fall with increasing speed into overwhelming indebtedness.

Financial performance of typical sheep farms

The statements in Table 2.2 are appropriate for a sheep farm of 6000 to 7000 DSE, running, perhaps 4000 adult sheep and 1600 weaners. Farm income is of the order of $20.00 per sheep. Fleece values of adult sheep have generally ranged between $15.00 and $30.00 in the last ten years. Many factors influence this value but some knowledge of the approximate productive value of sheep is essential to the process of advising producers about health and management strategies. Note also that profit is, in this example, less than $7.00 per DSE and would be close to zero if labour were included.

It is of interest to examine some statistics collected from sheep farms across Australia. Sheep farms reported here are those which derive their income predominantly from sheep products. The following statistics for these farms are supplied by ABARE (1994).

• The average farm in this category had 3,500 sheep
• The average farm debt in 1992-93 was $109,000. 26% of farms were debt free. 18% of sheep farm owners had equity below 70%. In Queensland, 36% of sheep farm owners had equity below 70%. Falling land values have eroded equity (without necessarily increasing debt levels), particularly in the pastoral zone. The average equity ratio for specialist sheep producers was estimated to be 86% at 30 June 1995
• Farm cash income, defined as total cash income less total cash costs, was $15,900 in 1995-96. Total cash costs include interest and, on average, 10% of total cash receipts were used to meet interest payments. Farm cash income for sheep farms over the last 19 years are shown in Figure 1. 38% of farms had negative farm cash income n 1995-96
• Farm business profit is defined as farm cash income less an allowance for family and farm operator' s labour and depreciation. 73% of farms had negative farm business profit in 1995-96. Data for the last 19 years are illustrated in Figure 2.1
• For beef cattle farms, incomes and profit were higher in 1992 to 1994 but average farm business profit has been negative since 1986 (Figure 2.1)

Figure 2.1 Sheep farm (left) and beef cattle (right) farm financial performance (ABARE 1996). The profits for the two enterprises are not comparable because they have not been scaled for size, DSEs or investment.

Figure 2.2 Wool price reflected by the market indicator, in nominal terms, from 1978 to 1996

The declining profitability of grazing enterprises in the early 1980s was associated with increasing costs and high inflation rates. Since 1986, income and profit on sheep farms have largely followed the wool price (Figure 2.2).

Wool prices peaked in April 1988 then declined rapidly. The market price was held artificially high by the reserve price scheme which dropped its floor price to 700 cents in June 1990 before being abandoned in February 1991. Prices commenced recovery in May 1993 only to fall again from mid-1995.

Conclusions from financial measurements

Two points arise from these statistics. First, the figures reflect average farm performances. The performance of the best farms is substantially better than the worst. Some of the differences between farms can be attributed to sheep management strategies which are associated, directly or indirectly, with health and production plans. Veterinarians have a role in developing and implementing these plans and can, therefore, assist in turning loss-making farms into profit-making farms.

Second, one has to wonder why farmers would tolerate such low incomes and such low returns on equity. Some part of the answer lies in the choice of lifestyle and in the fulfilment of family tradition but, from a purely financial point of view, farms have represented a good investment over the long-term because of capital growth - increase in the value of farms over time has proceeded faster than inflation. Provided cash returns are, on average, positive, farms do represent a good investment in the long term. To consistently achieve positive cash returns in the sheep and beef industries, however, increasingly demands high standards of management.

Economic analysis of enterprises and strategies

The previously discussed statements, the Balance Sheet and the P & L Statement, are useful documents in that they are readily available and they give a broad overview of the state of health of the business. They suffer from the drawback that they are prepared primarily for taxation purposes rather than as aids to identification of problem areas in the business structure or in its performance.

Consequently, other economic tools have been developed to provide insights into farm businesses and as an aid to farm planning. The two most commonly used are Gross Margin Analysis and Partial Budgeting but there is a range of other, more sophisticated techniques available, including linear programming.

Partial budgeting

A budget is a statement of expected income and expenses for a future period. In a partial budget, two or more alternative plans are compared with budgets which show only the extra expenses and extra income associated with the alternative. The budget is partial because only items which are relevant to the proposal are shown. It is a common procedure for evaluating veterinary intervention in grazing enterprises, such as improvements in worm control by changing the timing of drenching.

Gross Margin Analysis (GMA)

A Gross Margin is the difference (the 'margin') between gross income and variable costs. In Gross Margin Analysis, the gross margins of particular farm activities (eg, wool from a wether flock, wool and lamb production from a prime lamb flock, vealer production from a beef herd, a wheat crop) are calculated and compared to assist in farm planning decisions. GMA ignores fixed and financial costs because these are peculiar to each individual farm and to each farm business and do not reflect on the financial merits of the enterprise under review.

Gross income is the value of the total production from the enterprise for the time period under analysis. It is not the same as total income for the period, for it does not include products sold in the analysis period which were produced outside the analysis period, but does include products arising in the analysis period which remain unsold at the end of the period.

Variable costs are the expenses incurred for resources consumed during the analysis period which vary with the intensity of the activity. They are also called direct costs, because they are costs which can be attributed directly to the operation of the enterprise, rather than the existence of fixed resources.

We can use the P & L Statement in Table 2.3 to calculate a gross margin for the farm of J Smith & Son (Table 2.4). This farm runs sheep on 1000 hectares and has 6,000 DSE. In comparing farm activities, it is usually necessary to compare gross margins relative to another resource. Gross margins are frequently quoted on a per hectare basis, so the gross margin for the is $87 per hectare. Occasionally, gross margins are quoted on a per head or per DSE basis. These references are usually less useful because stock numbers are rarely the limiting resource for graziers; but land area and capital funds are. Gross margin per head is not constant with stocking rate, nor is gross margin per hectare. Producers are much more likely to wish to maximise gross margin per hectare than gross margin per DSE, and the two maximum points rarely occur at the same stocking rate.

Table 2.3 : Gross Margin Analysis

The gross margin is not profit. It is an index of profit. Profit in the above example could be calculated by subtracting fixed and financial costs from the gross margin. Fixed costs include wages (if paid) and depreciation.

The application of Gross Margin Analysis

Gross margins are used particularly for two purposes:

• for farm planning;
• comparing alternative management strategies for the operation of an enterprise; eg, to compare the gross margin likely to be achieved from a Merino flock keeping wethers to 1 years of age, rather than 5 years of age
• comparing alternative enterprises within the one farm business; eg, to compare the gross margin achievable from a Merino flock to that from a beef herd. Frequently, such comparisons lead to changes in the relative scale of enterprises on the farm. Since wool prices fell in the late 1980s, many graziers have scaled down their Merino flocks and scaled up their beef herds and their cropping operations, both of which have higher gross margins than Merino flocks in many districts
• for farm analysis; gross margin analysis can be used to highlight inefficient practices in the operation of farm activities, particularly by comparing details of the analysis to a 'district standard' or to other farms in the district (an inter-farm comparison)

There are a number of limitations to the application of GMA for these purposes but, provided care is exercised, the process can be particularly useful. The advantage of GMA is that fixed, financial, personal and tax expenses are ignored. These expenses can vary markedly between farms, they are difficult to allocate to parts of farms and are unaffected by the operation of the enterprise and therefore irrelevant to the comparisons.

One of the frequent criticisms of the technique is that it fails to properly account for differences in the requirements for capital resources, particularly capital funds and labour. Other criticisms include failures to account for longer-run effects of different enterprises, complementarity between enterprises on farm, and taxation and cash-flow implications involved in different enterprises.

Some expenses are difficult to describe as completely fixed or completely variable. Should fertilizer and pasture renovation be considered variable expenses? Labour is also difficult to allocate, partly because it behaves economically in a 'lumpy' or 'step-wise' fashion. If labour is a slack resource (under-utilized), a more labour intensive enterprise may not increase expenditure on labour. But at some levels of labour utilization, increases in intensity will add a quantum amount to labour expenses.

Modified Gross Margin Analysis

It is possible to overcome some of the principal weaknesses in GMA for evaluation of alternative sheep or cattle management plans by making allowance for changes in requirements for capital and labour. Whereas it would not be sensible to include changes in required capital as either an expense or source of income, we could allow for the opportunity cost of capital.

pportunity cost is effectively the income forgone by investment of capital funds into a particular activity. In many cases, opportunity cost is equivalent to the interest foregone by not investing in an alternative money-making scheme, or simply the cost of bank overdraft interest if additional funds are provided by a bank loan. In the examples which we will discuss here, the major changes in capital relate to the size of the flock or herd, so we introduce the opportunity cost of the value of the stock as an extra expense.

Accounting for labour expenses in GMA can be done by allocating a particular value to the cost of labour per head or per DSE. For example, in a GMA of the J Smith and Son flock, the allocation of labour costs has been $5.00 per wether, $7.50 per weaner, per ewe and per hogget (Table 2.4).

Table 2.4: Modified Gross Margin Analysis

Having measured the actual gross margin for last year, we are in a position to predict the gross margin of the sheep operation and compare it to the expected gross margin of a cattle enterprise.

Historically, gross margins have been set out and calculated in tabular form, as in Table 2.5.

The comparison of the gross margins for the two enterprises suggests that the Smiths could well consider at least a partial replacement of their sheep flock with a cattle enterprise. Additional factors that deserve consideration as well include any capital costs required for a move to cattle production (eg, strengthened fencing and water troughs, cattle yards), their own expertise in managing cattle and some assessment of the risk that each predicted gross margin is correct.

Table 2.5: Predicted Gross Margins for 2001 for 1000 DSE Merino sheep flock or 1000 DSE vealer cattle herd

Gross margin calculations often contain more detail than given here. For example, income might detail the expected wool cut and wool price from ewes, wethers, hoggets and weaners. Similarly, income from cattle might show the relative contribution from sale of cows, weaners and bulls. This enables some assessment of the degree of optimism or pessimism employed in the comparison. Details have been omitted here to avoid confusing the general application of GMA with the details, which vary from year to year.

We will use gross margins to evaluate procedures during this course, particularly procedures which involve major changes in the operation of the flock, such as alternative genotypes, changing reproductive rate and optimising stocking rate. One strategy we will discuss is the optimisation of flock structure and we can use a GMA approach to come to general conclusions about the optimisation of flock composition and the sensitivity of the gross margin to alternative compositions. Computer models are frequently used for this purpose because the number of mathematical relationships requiring recalculation for a range of strategies can be tiresome if done by hand and calculator, particularly where the results are sensitive to small changes in a large number of variables, such as the decline in productivity of ewes and wethers with age. White[2] used a comparison of gross margins to evaluate change in reproductive rate of sheep flocks and the gross margins were calculated by a computer model which considered a very large number of effects and interactions for a large set of environmental conditions.

GMA has also been used in veterinary fields to justify an increased level of veterinary services to dairy farms. A 4-year controlled study of a dairy herd health program conducted from the Melbourne University Veterinary School from 1973 to 1977 was evaluated in economic terms using a GMA[3]. Gross margins per hectare on farms using the herd health program were increased by $23, $1, $43, and $68 in each of the 4 years, relative to surveillance farms which did not have herd health programs. The method and the conclusions, however, were challenged by economists who argued, inter alia, that GMA was not the best method of analysing the results[4]. Johnstone et al[5] used GMA in analysing a field experiment to show that suppressive treatment (11 per year) with anthelmintics was financially superior to preventive, curative and salvage treatment. While the result was correct, it has since been demonstrated that the suppressive treatment was not optimal either - other untested strategies are now known to be better. This report is a straightforward application of GMA for those readers interested in a simple illustration of the technique. It should be noted that only a few income and expense items are used and the results could equally well have been analysed with a partial budget.

Recommended reading

Bell KJ (1988) Farm Profitability - key areas for veterinary involvement In Sheep Health and Production, University of Sydney Post-graduate Committee in Veterinary science, Proceedings No 110 p 169

[1] ABARE (1996) Farm Surveys Report 1996, Canberra

[2] White DH (1984) Economic values of changing reproductive rates In Reproduction in sheep eds DR Lindsay and DT Pearce, Aust Acad Science, Canberra, p 371

[3] Williamson NB (1980) The economic efficiency of a veterinary preventive medicine and management program in Victorian dairy herds Aust veterinarian J 56 p 1

[4] Alston JM and Ryan TJ (1981) The economic efficiency of a veterinary preventive medicine and management program in Victorian dairy herds: an alternative viewpoint Aust veterinarian J 57 p 572

[5] Johnstone IL, Darvill FM, Bowen FL, Brown PB and Smart KE (1976) Gross margins in a Merino weaner sheep enterprise with different levels of parasite control Proc Aust Soc Anim Prod 11 p 369