Leverage involves finding ways to increase the value or impact of a resource. Traditional discussions of leverage focus on financial leverage where equity funds (net worth) are augmented with borrowed funds to increase the size of a business. Under profitable conditions financial leverage increases the returns to the limited equity funds. Financial indicators such as the Debt to Asset Ratio are used to measure the financial leverage of the business.
Operating leverage is also used extensively in farm businesses. Operating leverage increases the returns to limited equity funds by using the money to “control” assets rather than “own” them. Assets can be controlled by renting or leasing the assets or hiring custom services. Because a smaller outlay of funds is needed to rent acres, a farmer can develop a larger business with the same amount of equity.
A typical example of operating leverage in farming involves renting rather than buying farmland. Table 1 shows typical investment estimates for corn and soybean production. The total investment for corn production for a farmer owning his/her land (including land, machinery, and operating expenses) is $5,110 per acre. However, the total investment for a renter (including land rent, machinery, and operating expenses) is only $790 per acre.
Size of farming operation
The number of acres of corn and soybeans that can be operated with a limited investment of $1 million is shown in Table 2. Four combinations of owned and rented land are shown. Because of the high investment requirements of owning land, only 198 acres ($1,000,000 / $5,046) can be operated if the land is purchased. However, if all land is rented, 1,377 acres ($1,000,000 / $726) of land can be operated.
The larger land base achieved through operating leverage can produce significantly higher returns if crop prices and/or yields are favorable. As shown in Table 2, net income under high grain prices increases from $71,542 if all land is owned, to $249,311 if all land is rented. Return on investment increases from 7.2 to 24.9 percent.
If crop prices are low, operating leverage can result in sharply lower net returns due to the higher cost of renting versus owning (debt free) land. Because land rental must be paid every year, the operating cost of producing corn and soybeans on rented land is substantially higher.
As shown in Table 2, if land is owned, low grain prices result in a net income of $24,970 and a return on investment of 2.5 percent. However, if all land is rented, low prices produce a net loss of $74,380 and return on investment of a negative 7.4 percent. So, the risk of loss under low prices increases substantially with operating leverage. The same relationship exists from low yields.
Because operating leverage allows more acres to be operated, investment per acre declines. As shown in Table 2, the investment per acre drops from $5,046 per acre if all land is owned to $726 per acre if all land is rented.
The Investment/Cost Ratio can be used to illustrate the ability of the business to absorb losses. Investment per acre is divided by the per acre cost of producing the crop. In the example, the ratio declines from 16.1 if all land is owned to 2.0 is all land is rented.
To put this ratio in perspective, if all land is owned, the operation can withstand 16 years of total losses (total crop failure, etc) before it becomes insolvent. However, if all land is rented, the operation becomes insolvent in two years.
So, in addition to being more vulnerable to losses, operating leverage decreases the ability of the operation to absorb losses.
The need for risk management is greater due to the increased risk exposure from operating leverage. Crop or revenue insurance, marketing strategies that reduce risk (options, etc.), and flexible leases are ways of reducing risk.
Just like financial leverage, operating leverage can substantially increase the size of the operation and the potential income from that operation. However, it also creates a substantially higher risk exposure because equity is spread thinly and the ability to absorb losses is reduced.