Profitability Benchmarks: A Tool for Cooperative Educators

Introduction

Cooperative mergers and consolidations are occurring at record levels in the United States, reflecting the current trends in decreasing numbers of full-time farms, increased costs, intense competition, and declining profits (Richards & Manfredo, 2003; Vandeburg, Fulton, Hine, & McNamara, 2000). Yet cooperatives remain an integral part of rural communities and provide important services to customers. This puts increasing pressure on Extension specialists and other professionals to find ways to help these rural cooperatives remain a viable business entity within their individual communities.

One obvious factor that is essential for cooperative survival is sound financial performance (Fulton, Popp, & Gray, 1996; Vandeburg et al., 2000). Given the importance of this factor, a system of profitability benchmarks was developed that could be used by professionals to help cooperative boards and managers better position themselves in this ever challenging environment. Financial benchmarks are particularly useful for diagnosing opportunities for improving business performance, although they are not well suited to describing the unique characteristics or all of the advantages of cooperatives relative to other organizational forms.

Our main objective is establishing appropriate financial benchmarks that help cooperative management teams and boards make sound operational and strategic investment decisions. These decisions should enhance the rate of return to local equity (ROLE). Once these benchmarks are developed and understood, Extension specialists can assist individual cooperative management teams assess their performance, note weaknesses, and address opportunities for improvement. In this article we first discuss the key financial characteristics and benchmarks. We then present our research results, followed by a discussion of how they can be used by Extension specialists in their educational programming. Recommendations for future research and training are presented in the final portion of the article.

Key Financial Measures

The first task was to identify those key financial characteristics that were associated with the greatest rates of return to local equity (ROLE) for agricultural cooperatives. The first step in this process included ranking cooperatives according to their ROLE and then categorizing the ranked cooperatives into subsets based on ROLE. The final step included calculating meaningful financial performance measures that firms might compare against the best performers and then establishing specific areas of improvement. The financial performance measures used in the analysis are listed in Table 1.

The rate of return on local equity (ROLE) is chosen as the primary measure of performance because it measures profitability attributed to local members' ownership. The ROLE is calculated for each cooperative firm as local savings (profits) divided by local equity. Local savings includes the cooperative's local operations only and does not include any regional investment. By the same token, local equity does not include regional investments. This simply provides a better picture of the firm's ability to generate savings or profits from their business operations.

Rate of return on assets (ROA) is chosen as a measure of profitability without firm debt structure, while the asset turnover ratio (ATR) reflects efficiency in deploying assets. Operating profit margin (OPM) is meant to reflect the firm's cost efficiency. The cost of financing the cooperative's assets is inherent in the weighted average cost of capital (WACC) calculation, and the overall debt structure of the cooperative is found in the debt to equity ( D to E) ratio. Although this is a brief synopsis of some important financial concepts, they include some of the most important relationships associated with business profitability. For a more detailed discussion, the reader is referred to Gitman, 2003.

Results and Discussion

Data was drawn from qualified financial statements that were provided by CoBank, a large lender to cooperatives. The sampled financial statements are for both farm supply and marketing cooperatives in thirty-four states. Ratios are calculated from statements ranging in years from 1995-2003 and are then averaged over the time period, using 505 cooperatives. Firms are sorted in descending order from the highest average rate of return on local equity (ROLE) to the lowest and categorized into quintiles, 101 firms are in each quintile. The average financial performance ratios for each quintile are found in Table 2.

The rows of Table 2 describe the quintile's various financial measures and average local equity. The columns of Table 2 indicate the quintile for which the financial performance measures have been calculated. The first quintile (1st) contains the 101 firms with the highest average ROLE over 1995-2003, followed by the next 101 firms (2nd quintile) etc. Values reported in the table are the averages calculated within the quintile.

The first quintile contains the highest performers with respect to ROLE, with an average rate of return to local equity of 16.44%, which is much higher than the mean ROLE of each of the other four quintiles. Important differences are also noted when comparing profitability per dollar asset (rate of return on assets, ROA), at 7.46% for the first quintile, cost efficiency (OPM) at 3.18%, and the cost of asset financing (WACC), at 7.48%. Thus, it appears that the first quintile's advantage in ROA, and ultimately ROLE, lies in its cost efficiency (OPM), which is higher with respect to each of the four other quintiles. The first quintile's weighted average cost of capital (WACC) is relatively larger than other quintiles' WACC averages, which may be a result of the opportunity cost of the cooperative's own capital. That is, the WACC is calculated as a weighted average of equity financing (proxied by ROLE) and debt financing, and the first quintile's ROLE is larger than all others.

It is interesting to note that size is not necessarily a factor with respect to profitability, at least within the first three quintiles because they do not differ substantially in debt structure ( D to E), amount of local equity, or total assets. Substantial differences are found between the 1st and 4th quintiles in terms of equity and assets, but it does appear, however, that the 4th and 5th quintiles are more similar in terms of asset and equity size than they are to the 1s quintile.

In summary, Table 2 is a snapshot of cooperative competitiveness during the years 1995-2003 as measured by financial performance. Cooperatives compete against one another to capture equity and business from producer-members, to garner the inputs and services from regional cooperatives, and to secure cooperative specific financing. The most competitive firms are those in the first quintile where, on average, the rate of return to local equity is 7% higher than the next quintile and substantially higher than the remaining quintiles. For firms in the lower quintile, improving cost efficiency would improve its competitiveness vis a vis other cooperatives.

Use in Extension Training Programs

What does this mean for Extension specialists? As stated in the introduction of this article, cooperatives are an essential and integral part of their rural communities. If they are to survive, they need some tools with which to accomplish this task. Based on this research, the Extension specialist might want to focus on ways to help cooperative managers and directors track and understand their financial ratios. As shown in this research, size alone does not correlate with profitability; a smaller cooperative has just as much potential for success as do the larger firms. In fact, cooperatives in the first quintile actually had fewer assets and equity on average than some of the other cooperatives that were less profitable.

Management efficiency is obviously important as represented by the ATR, but as shown by this study, it is not enough to guarantee success. Cooperatives need to analyze their financial positions relevant to the more successful ones in an attempt to see where weaknesses may lie and where there is room for financial improvement. As always, it should be noted that these are benchmarks and as such are not meant to be the final word on any cooperative's total performance. But they can serve as another tool for these businesses as they strive to compete in a very challenging environment.

It is our hope that this article provides some "concrete" evidence for Extension specialists who might need to motivate local cooperatives to improve their performance. These cooperatives may compare themselves against other cooperatives to see where they fit--are they performing at the level of other successful cooperatives or is there room for improvement?

More generally, cooperatives represent an innovative business structure that addresses shortcomings that private businesses may not be able to overcome. Specific research into the nature of the cooperative organizations can be found in James and Sykuta (2005), Chaddad, Cook, and Heckei (2005), Chaddad and Cook (2004). Professionals advising the formation of cooperatives, especially new generation cooperatives, may benefit from these articles.

Further Research

The next step in this process would be to survey cooperatives to add the more qualitative element of cooperatives' successful performance. The process has started to assess cooperatives by gathering some important quantitative data, but information with respect as "how" some of these financial ratios are actually accomplished would be very useful.

References

Chaddad, F. & Cook, M. (2004). Understanding new cooperative models: An ownership-control rights typology. Review of Agricultural Economics. Vol. 26. No.3 (Fall 2004): 348-360.

Chaddad, F., Cook, M., & Heckei, T. (2005). Testing for the presence of fianancial constraints in US agricultural cooperatives: An investment behaviour appracoh. Journal of Agricultural Economics. Vol. 56. No. 3. (December 2005): 385-397.

Fulton, J. R., Popp, M. P., & Gray, C. (1996). Strategic alliance and joint venture agreements in grain marketing cooperatives. Journal of Cooperatives 11, 1-14.

Gitman, L. J. (2003). Principles of managerial finance. Boston. Pearson Education, Inc.

James, H. & Sykuta, M. (2005). Property right and organizational characteristics of producer-owned firms and organizational trust. Annals of Public and Cooperative Economics. Vol. 76. No. 4. (December 2005): 545-580.

Richards, T. & Manfredo, M. (2003). Postmerger performance of cooperatives. Agricultural Finance Review. Vol. 63. No. 2. 175-192.

Vandeburg, J., Fulton, J. R., Hine, S., & McNamara, K. (2000, December). Driving forces and success factors for mergers, acquisitions, joint ventures, and strategic alliances among local cooperatives. Paper presented at NCR 194 (Research on Cooperatives) Annual Meeting, Las Vegas, NV. Online. Available at: http://www.agecon.ksu.edu/accc/ncr194/Events/2000meeting/VandeburgFulton.pdf