Use the DuPont ratio to analyze investment options
When making investment decisions for your farm, it’s easy to feel overwhelmed by the more than 20 financial models some experts advise you to run numbers through, some highly complex.
One of the best financial models is the DuPont ratio, and it’s surprisingly easy to use. It doesn’t require fancy software, and bottom line calculations can be done in a matter of minutes.
If you haven’t heard about it, you’re not alone. Experts estimate that only about 1% to 10% of farmers actually use it. Bob Wade farms 4,500 acres of corn, soybeans and wheat in Sonora, Ky., and is one of the few farmers who uses the DuPont model for key financial measurements.
To best allocate capital, Bob Wade uses the DuPont model.
"A farm has a lot of moving parts, and the DuPont ratio tells me return on assets and return on equity so I can make better business decisions," Wade says. "Because capital is a scarce resource with competing uses, you have take care of your cash, and the DuPont model can help."
Last year, Wade needed a pickup and priced a new one at $35,000 and a used one for $16,000. While it would have been nice to have a new one, the DuPont model showed that return on the additional capital for the new pickup was zero, so he opted for the used one. That left $19,000 to invest somewhere else.
"I was better off taking that capital and putting it into irrigation equipment or auto-steer," Wade explains. "We have invested heavily in irrigation equipment the past two years." This investment generates a high rate of return by boosting yields.
Wade also used the DuPont model to compare the return of owning versus leasing a combine.
"It showed me that leasing was a better use of capital," he says. "I don’t have $450,000 tied up, which would not be a good use of capital for an asset that is only used a small percentage of the year."
Annual leases allow Wade to access new or one-year-old units at a far cheaper cost than owning, which frees up capital for other investments.
Compare Asset Returns. The DuPont model can isolate your return from all possible asset purchases.
"Some assets are overpriced," Wade points out. One of the beauties of the DuPont model is that by comparing economic returns for any investment, it removes emotion, which is not your friend when it comes to purchases. "Taking the emotion out of investing is DuPont’s greatest advantage," he says.
Additionally, it doesn’t require a lot of number crunching, and the calculations can be made from data already present on the balance sheet.
Wade is a student of Warren Buffett. "He says to be wary of people in suits with Greek formulas," Wade says. "The biggest mistake people make is to make financial management too complicated."
- February 2014