Farm Business Analysis
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Farm Business Analysis Document Transcript

  • 1. College of Agricultural Sciences Extension Circular 375 Cooperative Extension Farm Business Analysis: Key to Pennsylvania Farm Profitability
  • 2. Contents Introduction 3 Figures 1. Dairy cow budget 6 Part I: Types, methods, and 2. Farm balance sheet 10 framework for analysis 4 3. Farm income statement 13 Types of analysis 4 4. Annual cash flow 15 Methods of analysis 4 5. Monthly cash flow 16 Comparative 4 Ratio 4 Projected 4 A conceptual framework for analysis 4 Part II: Tools of farm business analysis 6 Budgets 6 Balance sheets 8 Assets 8 Liabilities 8 Networth 8 Balance sheet analysis 8 Income statement 10 Farm operating receipts 11 Farm operating expenses 11 Adjustments 11 Net farm income 11 Income statement analysis 11 Cash flow 12 Analysis of cash flow 14 Part III: Using information from the farm business analysis 18 Signs of pending financial difficulties 18 Specific solutions for severe financial problems 19 Summary 21
  • 3. Introduction Good farm records are the Detailed and accurate foundation of good farm information is a necessary management. When farm component of the farm records can be used by farm manager’s decision making managers to quickly analyze process. This is why good situations and reach deci- farm records are the founda- sions, they are powerful tools tion of good farm manage- to use in enhancement of ment. farm profitability. The farm manager must be The first step in this process able to use business records is the establishment and in day-to-day decision maintenance of farm business making. Use of farm business records. But this is not records in management enough. Records that are requires ability to organize developed, but not under- information from the records, stood or not used, make no to select the relevant from contribution to the decision that which is less important, making process that is and to focus on the areas of essential to successful farm the business that need management. attention. (See Extension Circular 359, “Maintaining Farm business analysis—the and Using Farm Records,” for process of retrieving, organiz- a detailed discussion of farm ing, processing, and analyzing record keeping). information used in farm business decision making—is This publication provides a critical ingredient in the information that managers management of the modern will find helpful as they farm. Managers must be able approach the task of using to quickly respond to changes their farm records in making in the prices of the inputs business decisions. The first they buy and the products section is devoted to a review they sell if they are to of the types and methods of maintain farm profitability in analysis and a conceptual today’s rapidly changing framework of the analysis marketplace. Producers are process. The second part of no longer isolated from the publication considers changes elsewhere in the some tools of analysis that economic system. They must are available to the farm successfully respond to manager who has maintained changes in consumer tastes, an adequate set of farm government regulations, and records and who wants to use a whole host of other those records in business changes that occur in the analysis. Part three discusses world beyond the farm gate. the use of information from the farm business analysis. 3
  • 4. Part I: Types, Methods, and Framework for Analysis process involves computing projected earnings for the Types of Analysis Methods of Analysis ratios from farm business period (net farm income). A documents, such as the projected balance sheet Farm business analysis may Several methods are avail- balance sheet, and comparing estimates changes in assets involve either the whole- able in completing a farm the computed ratio with and liabilities and increases farm or a single enterprise. business analysis. These established standards. These or decreases in operator’s net Whole-farm analysis considers include comparative analysis, standards are not always well worth over the period business features that affect ratio analysis, and projected defined in terms of the projected. the entire business. It analysis. specific values that indicate includes balance sheet strength or weakness. A projected analysis is analysis which shows changes Comparative Analysis Variations in farm businesses dependent on development in total assets, liabilities and Comparative analysis can be between regions and differ- of enterprise and farm resulting net worth; income used for single farm compari- ences related to the type of budgets. (A budget is an statement analysis which son to compare performance enterprises also are a handi- estimate of sources of income shows changes in business of a particular farm business cap. However, this method and amount of costs). The receipts, expenses, and or an enterprise from a farm can be used as an early budgets provide information various accounting adjust- through time (for example, indicator of the condition of for the projection of income, ments; business cash flow comparison of performance a business. That preliminary expense, net income, and analysis which indicates the in Years 1, 2, 3). It can also condition then must be amounts of resources used. amount of funds entering and be used for multi-farm confirmed with a thorough leaving the business; and comparison of one farm unit study of the particular farm ratio analysis which can or enterprise with another unit for which the analysis is A Conceptual Frame- reflect what is happening in farm unit or enterprise. being completed. work for Analysis the entire business. Multi-farm comparison has limits because it is difficult to Projected Analysis The process encompassed in Only a part of the business, find comparable business Projected analysis is used the term “farm business typically a single enterprise, units. For multi-farm most frequently for cash flow analysis” can be conceptual- is considered in an enterprise comparison to be valid, it and income statement ized in three questions. These analysis. A study may be must be restricted to farm analysis, but may also be used are: made of the dairy enterprise units that use similar with other farm financial on a farm that includes a technology and operate documents such as the s Where are we? dairy herd, crops, and a under similar conditions. For balance sheet. The goal of s Where do we want to be? horticultural enterprise. A example, comparisons the projected analysis s How do we get there? single crop enterprise, such as between Southeast Pennsyl- depends on the document alfalfa, may be the item of vania and North-Central being projected. For example, These questions indicate that interest even though it is Pennsylvania farms or farm the projected cash flow a business analysis begins produced on a farm that also enterprises can be very estimates cash receipts, with a review of current produces hogs and corn. difficult to accurately expenses, and cash balance conditions – the resources Usually, more attention is interpret because of the for a future period. A available to the business, the given to specific items of cost different climatic and soil projected income statement current operating plan, the of production when complet- conditions that exist in those (also known as a pro-forma existing financial condition, ing an enterprise analysis. two areas. income statement) indicates and the skills and manage- Comparisons with other cash receipts and expenses as ment ability of the operator. similar enterprises are Ratio Analysis well as the projected ac- typically a part of this kind of Ratio analysis is used largely counting adjustments that Goals are a part of the analysis. in whole-farm analysis. This convert cash measures into process, perhaps best thought 4
  • 5. of as the end result of the to succeed. Various criteria to meet needs for taxes, the next section can be analysis procedure. A are available for evaluating insurance, debt repayment, calculated from the balance comparison of goals and labor efficiency. Some of the business expansion, and sheet and help to evaluate current position will indicate better criteria are value of family living, after payment relative strength or weakness. the changes needed to move production per worker, of cash operating expense. the business from the current quantity of product (pounds Typically, 70 percent to 80 position to the position it of milk sold per worker), and percent of gross receipts are will occupy at some future number of productive work required for cash expenses. date. units used on a specific farm. Thus, 20 to 30 percent of gross receipts are all that Planning based on analysis of Efficiency in use of capital is remain to cover fixed the business unit provides the increasingly important obligations and family living. answer to the final question. because of the long-term A business will progress upward trend in interest A quick estimate of required toward a goal only if plans rates. Rate of return on business gross receipts can be are developed that can move investment and rate of calculated by multiplying the it from where it is to where capital turnover are the most sum of fixed obligations and the operator wants it to be. often used measures of family living needs by four or efficiency in use of capital. A five. For example, if the The analysis process should rate of return on investment operating margin (cash begin with consideration of equal to current interest rates receipts minus operating the business as a whole. is a desirable goal, but rarely expenses) is 20 percent, the What are the strengths and obtained on most operating operator must sell $5 in farm weaknesses of the unit? farms. A practical goal for product in order to have $1 What is the financial rate of return is one equal to for family living expenses. condition as evidenced by or greater than the long-term the balance sheet and a average rate of return on Once an analysis of the review of net worth? How farm assets. This long-term whole business is completed, much debt is there? Is the rate has averaged about six it is helpful to become more debt manageable given the percent over the past several specific and consider individ- requirements for obligations decades. ual enterprises. Yields, such as taxes, family living amount of inputs used, and expenditures, and business Rate of capital turnover is costs of production become expansion? Does the income computed by dividing value important criteria for analysis statement indicate that the of farm production by total when considering a specific business is profitable? Are capital investment. Rate of enterprise. In evaluating an resources (land, labor, capital turnover realized on alfalfa crop, for example, the capital) efficiently used by different farms depends on farm manager should be the business? the major enterprises concerned with tons of forage produced. Poultry operations produced, feeding quality, In considering the above have a very rapid rate of the costs of producing the questions, one should capital turnover (more than crop, sale price, and net consider a number of factors. once per year in some cases) income. With the dairy The land resource is expen- while beef cow-calf opera- enterprise, pounds of milk sive and scarce and should tions usually experience a produced, inputs used (feed, receive special attention in low rate, requiring several labor) and their cost, and the analysis process. The years for a complete turnover income above cash costs are degree to which land is used of capital. Dairy operations important analysis criteria. for appropriate high-profit have an intermediate rate, crops (corn, alfalfa, soybeans) their capital turnover usually The balance sheet and the is an indicator of efficiency requiring about three years. income statement provide in land use. Other indicators information about the are crop yield per acre and Sufficient volume of business condition of the business as a value of total farm produc- is a key to farm business whole. Net worth and net tion per acre. success and should be farm income are factors that considered early in the can be used to quickly Labor must be used effi- analysis process. A farm must evaluate the business. ciently if the farm business is generate enough total dollars Certain ratios discussed in 5
  • 6. Part II: Tools of Farm Business Analysis The tools of business analysis budget helps the farm organizes and plans—both business earnings and are composed of the financial manager to organize informa- characteristics are reflected changes in owner equity. records maintained for a farm tion into a logical order. in a budget. business and the various Income and expense items Figure 1 is an example of an documents that are devel- otherwise overlooked are Budgeting is a basic farm enterprise budget. The oped from those records. often exposed through business analysis procedure. budget provides detailed Included in the list are development of a budget. Budget information is used in listings of sources and budgets, the balance sheet, projections of cash flow, amount of income and the income statement (profit The budgeting process is profit or loss, and the balance expenses. It indicates the and loss statement), and the extremely helpful when sheet. Cash flow projections amount of inputs required for cash flow summary. visiting a lender, both based on budgets are more the enterprise, such as because of the information accurate and can offer more quantities of grain, silage, available from budgets and detail than those using last hay, and other feed compo- Budgets due to the “business-like” year’s figures or strictly nents. Costs are divided into image created for the person estimates. The projected variable (cash) costs and A budget is an estimate of the who offers budgets to support income statement and fixed (overhead) costs. revenue, costs, and net a loan request. Lenders have balance sheet require budget Finally, the budget reflects income of a farm unit or an more confidence in a information to accurately returns above both variable enterprise. Development of a prospective borrower who reflect the best estimates of and total costs. Figure 1. Dairy Cow Budget for 17,000 Pounds of Milk and Replacements using 50 Percent Concentrate and 50 Percent Forage. Item Rate Amount Unit $Value $Total Income Milk sales $1 170 cwt 13.50 2,295.00 Cows culled $0.29 13 cwt 47.00 177.19 Calves sold $0.44 1 cwt 100.00 144.00 Gross Income 2,516.19 Variable costs Feed costs Corn grain equivalent $2.30 126 bu 289.80 289.80 Soybean equivalent Hay equivalent $90.00 5.4 ton 486.00 486.00 Corn silage (as fed) $20.00 8.9 ton 178.00 178.00 Soybean meal $16.80 14.9 cwt 250.32 Dicalcium phosphate $0.07 101 lb 7.07 Limestone $0.03 30 lb 0.90 Salt $0.07 91 lb 6.37 Supplemental feed cost 264.66 Other feed purchases Total feed cost 1,218.46 continued on next page 6
  • 7. Figure 1. continued Item Rate Amount Unit $Value $Total Other variable costs Building repairs 10.50 10.50 Equipment repairs 12.00 12.00 Bedding 40.00 40.00 Misc. livestock supplies 72.00 72.00 Breeding fees 36.00 36.00 Vet. & medicine 58.70 58.70 Milk testing 15.00 15.00 Gasoline, fuel, oil 10.60 10.60 Utilities 60.50 60.50 Insurance 10.00 10.00 Interest on operating capital 63.37 63.37 Coop dues (milk) 170 cwt 0.15 25.50 Milk hauling, freight 170 cwt 0.65 110.50 Marketing 170 cwt 0.12 20.40 Other cash costs 14.00 14.00 Advertising 170 cwt 0.05 8.50 Family labor Hired labor $5.00 25 hr 125.00 125.00 Total of other costs 692.57 Total variable costs 1,911.03 Fixed costs per cow or per unit Interest on cow and rep 10% 1,050 138.85 Equipment depreciation 10% 800 80.0 Building depreciation 10% 1,800 180.00 Management charge 5% 125.81 Total fixed costs 524.66 Total costs per cow or per unit 2,435.68 Returns above variable costs 605.17 Returns above total costs 80.51 Cost per cwt milk Gross income 14.80 Feed costs 7.17 Total variable costs 11.24 Total costs 14.33 7
  • 8. Assets composed of current, Balance Sheets A number of definitions are intermediate, and long-term Balance Sheet Analysis in order before proceeding obligations. Different names are used to with a discussion of using the The balance sheet provides a describe the document here balance sheet in farm Current liabilities are those cross-section view of the called a “balance sheet”. It is business analysis. An asset is which impact the business financial side of a business. A often called a financial something having economic within one year. They review of the balance sheet statement and sometimes a value that is controlled by an include bills or accounts due provides insight into the net worth statement. The term individual or firm. Assets within one year. Income tax, financial health of the “balance sheet” implies some include cash, personal FICA or self-employment business. Comparison of kind of balance as part of the property convertible to cash tax, real-estate tax, and notes balance sheets from a document. The balance given sufficient time, and are included in this category. business through time relates to the relationship real estate. The length of Principal payments on provides a general indication between assets on one side of time required to change the longer-term debts and of performance of the the document and liabilities item to cash determines the interest due within one year business. on the other side. That type of asset. The types of are also part of current balance results in the basic assets are current, intermedi- liabilities. The balance sheet analysis accounting equation which ate, and long-term. should begin with a compari- states that assets always equal Intermediate-term liabilities are son of total assets and liabilities plus owner equity. Current assets are those those items which are liabilities. The difference is which impact the business expected to impact the net worth. If total assets Balance sheets may reflect within one year. Current business after one year but exceed total liabilities, the both business and personal assets include cash, accounts within ten years. They business is solvent and net assets and liabilities or only or securities easily converted include debts due after one worth is positive. When business or only personal to cash, and commodities year but within ten years. liabilities exceed assets, the assets and liabilities. If both that will produce cash within Loans used to purchase business is insolvent and net business and personal assets twelve months. Inventory machinery or equipment and worth is negative. and liabilities are included, items (feed, fertilizer, fuel) breeding livestock are usually the result is a consolidated and livestock raised for sale classified as intermediate. The net worth of a business balance sheet. If only are current assets. (See on a given date indicates business assets and liabilities Extension Circular 359, Long-term liabilities are related owner equity and is a very are included, the document “Maintaining and Using to real estate and typically general indicator to a lender is a business balance sheet. If Farm Records,” for a more involve debts due after more of the risk involved in the document includes only complete discussion of than ten years from the making a loan. If net worth is personal assets and liabilities, inventories). initial date of the loan. Real large relative to total assets it is a personal balance sheet. estate mortgages are the in the business, the loan can Intermediate-term assets are typical obligation that be well secured and the The balance sheet provides a those items which are appears on the balance sheet chance of loss is small. A “snapshot” of a business’ expected to impact the as a long-run liability. smaller net worth may financial position at a business after one year but present an obstacle to specific point in time. It is within ten years. This Net Worth securing credit because risk of one of the most basic tools category includes assets used Net worth is computed by loss to the lender is greater. used in financial manage- in production of income. subtracting total liabilities ment and should be devel- Machinery and equipment, from total assets. Net worth A comparison of current oped on an annual basis by breeding livestock, retire- reflects a position at a point assets and current liabilities every farm manager. By ment accounts, and longer- in time and will differ day to from the balance sheet comparing end-of-year term securities are classified day or year to year. indicates ability of the balance sheets from consecu- as intermediate assets. business to meet cash tive years, the manager can There is no standard form for obligations as they come due. determine changes that are Long-term assets are primarily the balance sheet. However, A business that is able to occurring in the various types related to real estate. Land there is a degree of uniform- meet its current cash of assets and liabilities. and improvements are the ity among these documents. obligations as they come due Changes in net worth, usual long-term assets. Regardless of the source, a possesses liquidity. through time, can also be balance sheet will include determined by comparison of Liabilities current assets and liabilities, The balance sheet of a balance sheets from several Liabilities are the financial intermediate assets and business in a healthy finan- years. obligations incurred by an liabilities, long-term assets cial condition will reflect an individual or firm. They are and liabilities, and net worth. excess of current assets over 8
  • 9. current liabilities. Typically, The debt structure ratio (or will have a net capital ratio liabilities (and other catego- that excess should be one- current debt ratio) measures of approximately 2.5 or more. ries) are arranged on opposite and-one-half to twice as current liabilities relative to This means that owner sides to facilitate comparison. much in current assets as in total liabilities. It is calcu- equity is 60 percent or more For example, current assets current liabilities. The excess lated as follows: of the total assets used in the on this balance sheet total is needed for several reasons. business. $301,025 and current Debt structure ratio liabilities are $59,232. A first reason is to serve as a = Current liabilities The debt-equity ratio is a financial cushion in case of Total liabilities second measure of business Various balance sheet rapid change in price of the solvency. The debt-equity analysis criteria discussed property making up the The debt structure ratio ratio reflects the relationship above can be illustrated with current assets. A rapid drop indicates the part of total between borrowed and equity Figure 2. For example, in price will destroy the debt that must be repaid (or owned) capital used in solvency can be determined liquidity of a business that within one year. A ratio of the business. It is computed by comparing total assets and has barely enough current 1:4 (or .25) indicates that 25 by dividing total debt by total liabilities. Total assets assets to cover current percent of total debt must be owner equity. Lenders often of $1,207,771 exceed total liabilities. repaid within one year. The refer to this ratio because liabilities of $466,592; so the higher the ratio, the greater they prefer to make loans to business is solvent. The A second reason that excess will be the drain on cash that borrower who has an difference between assets and current assets indicates good reserves and the more the equity of 50 percent or more liabilities is net worth—a financial health is that this risk of being unable to repay of total assets used in a second criteria for analysis of excess is the source of current debt obligations on business. Thus, lenders prefer the balance sheet. Net worth working capital for the time. A high ratio of current a debt-equity ratio of less in this case is $741,179. business. Working capital is to total liabilities may than one. This indicates that the source of funds for indicate a need to refinance. the owners contribution is Net capital ratio computed current operating expense— The refinancing process more than that of the lender. from Figure 2 is 2.59 the items that must be typically converts part of the ($1,207,771/$466,592). This purchased on a day-to-day short-term debt to a longer- A financially healthy indicates good financial schedule to keep the business term obligation. business will generally have a health for the business operating. If there is a debt-equity ratio of .67 or represented by Figure 2. The deficiency of working capital, The debt structure ratio less. However, this can vary debt-equity ratio is .63 the business must borrow should be interpreted with depending on the quality of ($466,592/$741,179). This additional funds or it must care. It probably should be management, the enterprises indicates there is 63 cents of liquidate intermediate assets used only in association with that are the source of debt for each dollar of to secure working capital. other analysis variables to put income, and the level of equity—the operator owns The procurement of addi- it into perspective. For profits. Perhaps the most somewhat more of the tional credit often takes time. example, an individual with valuable feature of this business than the lender. If intermediate assets are $500,000 net worth and measure of solvency is the This also indicates a healthy liquidated, the assets that $3,000 of liabilities, com- trend value—that is, the financial condition. produce income for the posed of $2,000 current changes that occur to the business have been removed liabilities and $1,000 ratio through time. If the Liquidity is measured by and future income flow will intermediate-term liabilities, ratio deteriorates through comparing current assets be reduced. Thus, asset has a debt structure ratio of time—that is, it increases in with current liabilities. Figure liquidation is not a viable 2:3 (.667) but is in no absolute size, there is reason 2 indicates a large surplus of long-term alternative. immediate danger of finan- for concern and a careful current assets over current cial distress. review of the farm business liabilities—thus a high A number of ratios have should be undertaken. A degree of liquidity for this been developed to help in The net capital ratio is a rising debt-equity ratio business and an adequate review of the balance sheet. common measure of sol- means that debt is increasing. supply of working capital. These should be considered vency. The net capital ratio The current ratio provides as useful tools for initial is total assets divided by total Figure 2 is a typical farm much the same relationship evaluation of the document liabilities. A business is balance sheet. Current, in ratio form. The current but not as the final answer to solvent if the ratio is more intermediate, and long-term ratio for this business is 5.08 the question ‘what is the than one—that is, there is assets are itemized on the left ($301,025/$59,232), which is problem in the business’? more than one dollar of half of the page and similar well above the level consid- They are general indicators assets for each dollar of categories of liabilities are ered necessary for good pointing to a need for further liabilities. However, a arranged on the right half of financial health. study. financially healthy business the page. Current assets and 9
  • 10. Figure 2. Farm Balance Sheet Farm Balance Sheet (Statement of Assets and Liabilities) X Estimated market value Cost less depreciation Date, January, 1988 Assets Liabilities & equity Current $ Current $ Cash on hand and in bank 2,000 Accounts payable Notes & accounts receivable 11,940 Bank operating loans Market livestock 92,420 Intermediate debt due this year 11,375 Crops & produce for sale Long term debt due this year 3,938 Feed & farm supplies 149,065 Other Growing crops 1,600 Interest-intermediate loans 12,602 Other (marketable securities) 40,500 Interest-long term loans 31,317 Cash surrender value - life insurance Total current 59,232 Savings 3,500 Intermediate (due in 1 to 10 years) Total current 301,025 Term notes (less current portion) Intermediate PCA 48,133 Breeding livestock 154,430 PA National 50,000 Machinery & equipment 85,321 Total intermediate 98,133 Other Long term (over 10 years) Depreciable property 25,073 Term notes & mortgages (less current portion) Total intermediate 264,824 Land Bank 309,227 Fixed Total long term 309,227 Land and buildings Total liabilities 466,592 Land 460,500 Net worth 741,179 Depreciable property 143,422 Dwelling 38,000 Total fixed assets 641,922 Total assets 1,207,771 business ownership. While schedule depending on what Three major sections in the Income Statement appreciation in value of is needed for management income statement are business assets may increase purposes. Most farm busi- receipts, expenses, and The income statement is the owner net worth, that source nesses use an annual income adjustments. The receipts only tool of farm business of funds is available only if statement. The annual and expenses section reflect analysis that measures the business is liquidated. In statement is consistent with cash flow during the year. profitability. Budgets, the contrast, the earnings the production cycle for The adjustments are neces- balance sheet, and the cash reflected on the income livestock and crop enterprises sary to convert cash flow to flow projection are valuable statement are the result of and with calendar year annual earnings by including and essential management operations. Those amounts record-keeping and tax filing inventory change, accounts tools, but they do not tell the may be used for current activities. This approach payable and receivable, and manager if the business is expenditures or as an permits comparison of farm depreciation. Consolidated profitable. addition to owner equity. profitability from one income statements also calendar year with profits include nonfarm income and The income statement The income statement can from prior and subsequent family withdrawals in measures business earnings be computed monthly, years. calculations. resulting from business quarterly, semi-annually, operation as opposed to annually, or on some other 10
  • 11. Farm Operating Receipts only adjustment required is Net Farm Income not deducted in computing Farm operating receipts are to include value of the Net farm income, (farm net farm income, then the first group of items on the products in gross farm profit or loss based on expenditures for family living income statement. This receipts. operating earnings), is net have a priority claim on part group includes cash receipts cash operating income (farm of the amount reflected in from grain and forage crops, Inventory change is a second receipts minus farm ex- net farm income. livestock and livestock and very important adjust- penses) plus the adjustment products, government ment to be made on the for value of products con- Interpretation of net farm payments, and other sources income statement. Inventory sumed by the family, plus income requires good of cash receipts from farming. change is determined by inventory adjustment, plus judgement on the part of the The total of this group is comparing beginning and adjustments for accounts evaluator. More is generally gross farm operating receipts. ending inventories from the payable and receivable, and better, but evaluation of the balance sheet, the goal being minus depreciation. The level of net farm income Farm Operating Expenses to determine the increase or consolidated income state- from a particular farm must Farm operating expenses are decrease in inventory that ment includes nonfarm be completed with a view to the second group of items occurred during the year. income since employment type and size of operation. A found on the income Items that may be the source off-the-farm has become an $7,500 net farm income from statement. Operating of inventory change include increasingly important a 60-cow beef herd might expenses include outlays for feed and grain, seed, fertil- income source in recent reflect an excellent return. seed, fertilizer, chemicals, izer, fuel, livestock, and other years. It may also include But that level of net farm machine hire, feed, veteri- farm property. A larger end- withdrawals for family living income from a 60-cow dairy nary expense, interest, and of-year inventory means in arriving at a net figure. herd is unacceptable, based several other cash farm some farm production is Choice of farm business, on recent rates of return for operating expense items. The reflected in inventory items personal, or consolidated successful dairy operations. total of these items is gross rather than in farm receipts. income statement is at the Thus, it is necessary to have farm operating expense. That larger inventory must discretion of the individual standards for comparison in Subtracting gross farm be included to arrive at an farm operator. evaluating net farm income. operating expense from gross accurate measure of farm farm operating receipts yields production for the year. The standards needed in net cash farm operating Income Statement evaluating net farm income income. Accounts payable and receiv- Analysis are available for some farm able must be considered as types and enterprises, but not Adjustments the income statement is Analysis of the income available for others. In The adjustments included on developed. If accounts statement involves reviewing Pennsylvania, very good the income statement payable have increased several variables available or information is available account for those factors that during the year, this repre- easily calculated from that about dairy farms; other farm affect farm earnings but are sents expenses incurred (and document. types are more difficult to not reflected in a cash properly charged against the evaluate. Regional differ- transaction. Included among year’s production) but not Net farm income is the ences do exist and the the adjustments are value of paid. This can be resolved by “bottom line” on the income evaluator should be careful farm products consumed by adjusting farm expenses statement and a good place that the standard being used the farm family, changes in upward to account for the to begin the analysis proce- is the appropriate one for the inventory, and changes in unpaid expense. If accounts dure. This figure represents location of the farm under accounts payable and receivable have increased return to unpaid operator and consideration. receivable. during the year, products family labor, equity capital, have been produced and and management. Over the The operating ratio is another The value of products con- marketed but payment has long- term, net farm income is variable that can be used to sumed by the family repre- not yet been received. This the amount available for evaluate net farm income. sents production by the represents production discretionary use by the The operating ratio is total business. It is necessary to attributable to the year that family and for business operating expense (cash farm add this amount to farm should have been reflected in development. If a withdrawal expense) divided by gross receipts in order to accurately farm receipts. To adjust for for family living is made in income. The ratio converted reflect total value of produc- that, it is necessary to computing net farm income, to a percentage reflects the tion by the business. Ex- increase receipts in the then net farm income part of gross income that is penses related to producing amount of increase in represents the amount required to cover farm home-consumed products are accounts receivable. available for business operating expense. typically included in farm expansion and risk-taking. operating expense. Thus, the When family withdrawals are 11
  • 12. The difference between the comparison only if the farm gross farm income to arrive the flow of expenditures out quantity “100” and the operator is willing to liqui- at net farm income. of the business. Those flows operating ratio as a percent- date the business and apply are important because they age is the operating margin. the funds in the nonfarm indicate when cash surpluses For example, if the operating investment. Historically, Cash Flow or deficiencies will occur. ratio as a percentage is 70, capital invested in farming the operating margin is 30 has not yielded as much The cash flow plan is an Cash flow says nothing about (100-70). This margin return as capital invested in essential financial manage- profitability of the business; represents the share of nonfarm securities. A more ment tool for Pennsylvania profitability information is income that is available to valid comparison for a farmers. It addresses one of available only from the cover family living, business continuing farm business is the most serious financial income statement. Cash flow fixed obligations, and one made with other similar problems faced on farms includes no consideration of business expansion. Gener- farms in the area or with the today—the control of cash inventory change, accounts ally, the operating ratio (or long-term rate of return to flow. The cash flow plan is payable or receivable, or percentage) should be less agricultural assets. The latter the focal point of the annual depreciation. The absence of than .75 (or 75 percent) rate has averaged about 6 farm planning process. If the these important adjustments which results in an operating percent for a number of cash flow plan is prepared means that profitability margin of 25 percent or decades. (The reader should carefully and in sufficient decisions based on cash flow more. be aware that this low rate of detail, it will provide a will be grossly misleading. return to farm investment financial picture of the Rate of return on total has been compensated to operator’s enterprise selec- A cash flow projection can capital is a third analysis some degree by appreciation tions, input needs, feed be developed in either of two variable computed by making in land value. Unfortunately, requirements, credit needs ways. Information from last minor adjustments to net this gain can be realized only and repayment capacity, year can be used to estimate farm income from the if the farm business is family living needs, and current year revenue and income statement. Rate of liquidated). marketing plans. expenses. Adjustment of last return on capital is net farm year’s information will be income plus interest paid as a Comparisons with other To be most useful, the cash necessary, depending on farm operating expense, similar farm units must be flow should be prepared on a price change and change in minus an allowance for approached with a cautious projected basis; that is, it the farming operation. This operator labor, with the total attitude. It is essential that should represent a plan for approach is quick but may divided by average capital the units selected for the future. Actual cash flow not provide a high degree of investment. (Remember that comparison are those with (farm receipts and expenses) accuracy. net farm income is the return similar crop and livestock can then be compared with to unpaid family and operator programs, using similar the projection to provide an A more exacting approach is labor, equity capital, and technology, and located in early check on business to carefully plan the coming management). similar climatic and soil progress and an opportunity year’s farm operation and areas. to make timely adjustments if base the cash flow on those Example: A farm’s income required. plans. Several steps will be statement shows net farm Figure 3 is a typical farm required in this process. income of $30,000, interest income statement. Cash farm Cash flow should be prepared paid of $14,000, and an receipts are itemized on the on both an annual and First, the scope of crop and allowance for unpaid left side. An adjustment is monthly basis. The monthly livestock enterprises should operator labor of $12,000. made in the receipts section cash flow is of critical be determined and detailed Total capital investment for for accounts receivable. The importance in determining revenue and cost data about the farm is $340,000. Rate of sum of cash farm receipts and specific dates when loans are those enterprises should be return to total capital is: the adjustment for accounts needed, when debt can be gathered and organized; that receivable is gross farm repaid, and when inputs will is, enterprise budgets should $30,000 +$14,000 - $12,000 income. Cash farm expenses be purchased. The use of the be prepared. In addition to $340,000 are itemized on the right side cash flow in estimating number of acres or number of =9.41 % of the form with an adjust- amounts and time of finan- head of each enterprise, ment for accounts payable cial transactions causes some decide on the technology to The value computed for rate included. people to view the document be used and the inputs, of return to total capital can as a whole-farm budget. including machinery opera- be compared to rates of Depreciation is added to cash tions, that will be needed return for stocks, bonds, or farm expenses to arrive at The cash flow projection based on that technology. other nonfarm securities. total farm expenses. That estimates the flow of revenue This crop and livestock However, that is a valid amount is deducted from into the farm business and information can be used to 12
  • 13. Figure 3. Farm Income Statement Farm Income & Expense Statement For the period 1/1,1988 to 12/31, 1988 Income $ Livestock & products Expenses $ Milk 103,855 Livestock purchases 1,627 Dairy Stock 10,300 Feed 28,173 Crops 1,689 Other livestock expense 8,124 Custom work 405 Crops Rents, share income Seed 2,963 Governments payments 769 Fertilizers 6,524 Misc farm income 1,863 Chemicals Total farm cash sales 118,881 Other Closing current accounts receivables $620 Marketing costs Less: opening current accounts receivables $500 120 Custom work, equip. rentals 1,252 Total farm sales 119,001 Hired labor 7,106 Plus inventory change (ending minus beginning) Fuel, oil 4,431 Livestock ($110,815 - $110,000) 815 Equip repairs 4,607 Crops ($46,857 - $40,000) 6,857 Bldg, fence repairs 1,334 Supplies ($700 - $1,000) (300) Interest 9,662 Gross farm income (A) 126,373 Electricity 3,375 Taxes, insurance 3,618 Car expenses 1,071 Rent 2,238 Other farm cash expenses 2,857 ToIal farm cash expenses 88,962 Closing current accounts payable $884 Less: opening current accounts payable $500 384 Total farm purchases 89,346 Plus depreciation 17,532 Total farm expenses (B) 106,878 Net farm income (A-B) 19,495 determine annual cash flow. amount of revenue that will be needed and their amount, received from investments, be produced. The result of when the old bull will be and other nonfarm source Step two is to estimate this process is an estimated sold, and when a new pickup income should be included in monthly enterprise income monthly flow of income and will be purchased. These the month they are expected and expenses. To arrive at expenses for all crop and transactions are included in to be received. monthly cash flow, it is livestock enterprises. cash flow, depending on necessary to estimate when when the transaction occurs Family living expenditures variable inputs will be Transactions related to and the amount of funds and taxes are included in the needed and when machinery capital investment must be received or expended. month they will occur. Times operations will be performed. planned. This will include of extra expense, such as Cost of the inputs and purchases, trades, or sales of Nonfarm earnings should be holidays or vacations, should machinery operations must capital items. Thus, it is included in the projected be planned and included in be determined. It is also necessary to decide when consolidated cash flow. the consolidated cash flow. necessary to determine when tractors will be traded, when Wages and salaries earned off products will be sold and the the funds for a new barn will the farm, interest income Debt repayment should be 13
  • 14. planned and included for the for each of these should be month in which surplus funds compared with actual will be available to make experience at least on a payment. Planning this monthly basis. Major feature of cash flow requires a differences between projected review of receipts and and actual cash flow may expenses by month to indicate the need for changes determine when surplus in crop or livestock produc- funds are expected to be tion plans, planned new available. capital investment, or planned family living The cash flow summary from expenditures. the previous year is helpful in “fine-tuning” the projected Caution must be exercised in cash flow. If the farming using cash flow to evaluate operation in the coming year the health of a farm business. will be similar to the opera- Cash flow can only indicate tion during the previous year, if current returns will pay comparisons may help in current expenses, debt, making adjustments. Those family living, and other adjustments should be based current obligations included on expected price or cost in the cash flow document. differences, production An analysis of the health of a differences due to weather farm business should include variations, or other differ- a review of the balance sheet ences between the year being and the income statement, as projected and the one just well as the cash flow. completed. Figure 4 is an annual cash flow projection. It indicates Analysis of Cash Flow the expected sources of cash receipts and estimated cash The analysis of cash flow is expenses for the year. largely a matter of continu- Principal payments and ous monitoring of receipts family living are included and expenditures and and a year-end cash balance comparing what actually is computed. happens to projected cash flow. A primary advantage of Figure 5 is a monthly cash cash flow analysis is that it flow. It uses the same broad provides an early-warning categories of income and system for the business in expense as the annual terms of financial affairs. document, but the estimates When major differences are provided for each month. between projected and actual Thus, the income from sale cash flow occur, the manager of milk, expected to be should complete a review of $117,000 for the year, is financial transactions and divided into estimates of production practices to $9,750 per month on the determine the reason for the monthly cash flow. The difference. annual $27,000 feed cost is divided into estimated The focal points for cash flow monthly feed expense analysis are total cash amounts. Cash balance is receipts, total cash expenses, computed on a monthly basis new debts, interest and for the monthly cash flow. principal payments, and cash balance. Projected amounts 14
  • 15. Figure 4. Annual Cash Flow Annual Cash Flow Line Cash inflow Line Cash outflow Operating income $ Operating expenditures $ Crops 28 Labor, hired 1,200 1 Corn 29 Machinery repair & maintenance 6,000 2 Milo 30 Building & fence repair 1,200 3 Wheat 5,400 31 Interest 9,924 4 Soybeans 4,620 32 Hay 2,500 5 Cotton 33 Feed bought 27,000 6 Grass & clover seed 34 Seeds, twine, etc 2,762 7 Hay, silage 35 Crop chemicals 2,482 8 Other, crop 36 Fertilizer & lime 9,748 9 Government payments 37 Machine hire 255 Livestock 38 Breed fees & livestock supplies 9,900 10 Milk 117,000 39 Vet & medicine 1,800 11 Eggs, wool 40 Gas, fuel, oil 7,396 12 Calves 3,540 41 Rent 13 Market hogs 42 Taxes 4,000 14 Other market livestock 43 Insurance 800 Miscellaneous 44 Utilities, elect, phone 3,000 15 Custom work 45 Freight & trucking 475 16 Cash rent 46 Farm auto 500 17 Other, farm 47 Feeder cattle 18 Total operating income Add L 11-17 130,560 48 Assessment 1,380 Capital sales 49 Other expenses (2% subtotal) 1,846 19 Breeding beef 50 Total operating expense Add L 28-49 94,168 20 Breeding hogs Capital expenditures 21 Breeding dairy 7,800 51 Breeding beef 22 Machinery & equipment 52 Breeding hogs 23 Total capital sales Add L 19-22 53 Breeding dairy 24 Total cash income L 18+L 23 138,360 54 Machinery & equipment 9,000 Other income 55 Bldgs & land improvements 16,000 25 Nonfarm income 6,000 56 Total capital expenditures Add L 51-55 25,000 26 Loans 57 Total farm expenditures L 50+56 119,168 27 Total cash available L 24+25+26 144,360 Other cash outflow 58 Principal payments 7,000 59 Family living 16,600 60 Total cash outflow L 57+58+59 142,768 Summary 61 Cash balance L 27-60 1,592 62 Accumulated borrowing 15
  • 16. 16
  • 17. 17
  • 18. Part III: Using Information from the Farm Business Analysis After the tools described in fuel may indicate more severe may involve very low net hold in business assets. Level previous sections have been financial problems in the farm income or net farm of family living expenditures applied to data from a not-too-distant future. income that is less than the and family goals are impor- specific farm business, and manager considers suitable tant factors. A family that analysis information has been A shortage of working capital for the type of farm and size expects frequent recreational developed, it is necessary to is a second indicator of of investment. While analysis outings, long vacations, a interpret the results prior to approaching financial of the farm business should luxury car, a new residence, making and implementing trouble. Working capital is be a part of the on-going and substantial amounts set management decisions. That the difference between process of farm management, aside for the children’s process of interpretation current assets and current earnings problems (real or college education require involves focusing attention liabilities on the farm perceived) are the most larger earnings that a family on the information that is balance sheet. An early sign common reason analysis with more moderate aspira- most relevant to the issues at of developing financial activity is undertaken. Some tions. Also, the family with hand. The manager’s goal is problems is a small, or of the symptoms of earnings 80 percent equity in business to understand the environ- decreasing, working capital problems are negative cash assets does not require the ment in which the business position. The farm operator flow, net worth not increas- higher level of earnings operates, and to develop a who has a negative working ing from year-to-year, and required for debt service if strategy that will help it to capital position can be failure to service debt on a equity is only 40 percent. grow and prosper in the almost sure of having timely basis. future. difficulty obtaining short- Once the scope of the term credit. The income statement is the earnings problem is estab- focal document in consider- lished, the manager should Signs of Pending Failure of earnings (net farm ing problems with earnings. become more specific in his/ Difficulties income) to grow from one This is the only tool of her review. Is the problem There are certain finance year to another is an “early- financial analysis that caused by temporary or signs that provide early warning” signal of potential provides information about permanent influences? warnings for pending difficulty. The manager profitability of the business. Temporary factors include financial difficulties. A farm should review enough years Thus, to study earnings, the low-yields (caused by operator who has detailed to determine what has manager should start with weather, insects, disease), records and who properly happened through time. Is the income statement. Net prices fluctuation, or inven- organizes the information this the first year for the farm income and the tory change. If low earning from those records, will be problem or has it persisted for percentage returned to are caused by one or more of able to note the early several years? The manager capital are two analysis these temporary conditions, warning signs in time to should also establish if the variables that should be the manager need go no make adjustments. Others earnings result in a positive reviewed. further. He/she should learn of those signs much cash flow or if the deficiency determine the adjustments later, often when it is too late is such that existing income Analysis of the earnings required by the temporary for easy solutions. will not pay operating costs, problem can begin by factors, make those adjust- family living, debt payments, determining the size of the ments, and proceed with Accounts payable increasing or and fixed obligations such as problem and how long the longer-run operational inability to pay bills on time, taxes. problem has persisted. The decisions. are one of the very early signs size of the earnings problem of approaching financial The initial issue on which often relates to the lifestyle Permanent influences usually problems. The lack of the manager may want to and expectations of the relate to basic management sufficient funds for payment focus attention is the individual family as well as decisions. If the earnings of bills for fertilizer, feed, and earnings problem. That issue the amount of equity they problem relates to manage- 18
  • 19. ment, the manager should computerized transitional pounds of milk per worker, their management and establish if it is an organiza- planning to determine both for example, in the case of finances so thin that a tional problem or an opera- the “best” farm organiza- the dairy enterprise? Are reduction in size of unit tional problem. Organiza- tional plan and the year-to- fixed costs average or below could improve profits and tional problems involve the year changes that should be when compared with cash flow. way resources (land, labor, made in moving from the surrounding similar farms? capital) are used. Operational existing plan to a better one. The decision by a manager to problems relate to day-to-day (Linear programming is a Once the manager has “do something else” is a decisions such as when computerized farm planning established the cause of the dramatic change and usually particular tasks are done, tool available through Penn business’ performance a stress-filled one. It usually how technology is used, and State county extension problem, (organizational or means a complete reorganiza- the amount of variable input offices. Transitional planning operational), he/she must tion of the business assets to be applied to fixed is available as part of the determine the courses of and liabilities. Depending on resources. FinPack group of computer- action that are open to help the individual situation, ized farm planning tools and improve the financial health alternatives such as renting When the nature of the is also available through of the unit. Each farm unit is out land and other assets, off- earnings problem is estab- Penn State Cooperative unique, but three broad farm employment, or selling lished (organizational or Extension). courses of action are avail- part or all the assets may be operational), the manager able. These are: (1) do a considered. must act to correct the If the earnings problem better job of what is now problem. If low earnings relates to operational factors, being done, (2) do more (or relate to how the business is the manager must determine less) of what is now being Specific Solutions for organized, it is necessary to why the current operating done, or (3) liquidate the Severe Financial change the farm plan to system is not working and farm business and redirect Problems better utilize available implement the necessary the use of resources. resources. Enterprise budgets changes. This will entail an Severe financial problems will help in this process. analysis of enterprise yields, If the manager elects to try to have no easy solutions. The They indicate the resource receipts, costs, and value of do a better job with present solutions often require drastic requirements and potential farm production per worker. resources, it means concen- steps. An assumption earnings from each enter- The manager also should tration on improving underlying these solutions is prise. The manager should review resource use for each efficiency in the operation that the problems are related proceed with a view to enterprise, with emphasis on and management of the to financial difficulties rather maximizing profitability productive efficiency for business. This includes than management of produc- given the constraints crops and livestock and production, marketing, and tion. The following solutions imposed by supply of re- efficiency in use of land, financial management. The are intended for farm units sources and available labor, and capital. Crop goal is to increase earnings with more serious financial technology. enterprises should be studied per unit by increasing yields, problems. with a view to how much of improving marketing to Excellent planning tools are the available land is used for increase revenue, or reduce Increasing income without available for the manager’s high-profit crops. Are crop costs of production. Restruc- incurring added expenses will use in finding the best production costs under turing debt (refinancing help solve financial prob- organizational plan for his/ control? Are machinery costs short-term debt) may also be lems. In days when farm her farm. Linear program- too high? Are crop yields a required part of the debts were small and interest ming is a computerized comparable to neighboring adjustment process. payments were low, it was process that can be used to well-managed farms and are often possible to obtain a find the most profitable farm crops marketed efficiently? If the manager elects to do part-time job to solve plan given the resources more or less with the current temporary financial difficul- available. This procedure Livestock enterprises should farm organizational plan, it ties. The magnitude of debt involves development of be reviewed with particular means he/she has recognized on some farms today makes budgets for all possible attention to both economic a source of inefficiency and this solution less feasible. It enterprises, listing the kind and production efficiency. Is will act to correct that is, however, one alternative and amount of available level of milk production per problem. For example, if that should be examined, resources, and then solving cow or number of pigs there is excess capacity in particularly at those farms mathematically (using the weaned per litter comparable machinery, equipment, or where family labor can be computer) for the unique use to those of successful farms in labor, land may be rented to substituted for operator labor of resources that maximizes the area? Are livestock better utilize the under-used and where the nonfarm job profit. Linear programming product sales per worker at resources. In contrast, some will help to reduce the debt can be combined with efficient levels: 500,000 farmers may have spread burden. 19
  • 20. Maintaining a good working Examples of this may be capital position is a key goal wasteland, timberland, of financial management. minerals, or a land area This can be accomplished by separated from the main farm properly structuring debt. by a road or other barrier. It When purchasing capital could also be a set of build- assets, it is important to ings. Or, it may be some properly finance them, so as unused or under-used to maintain a correct balance machinery. There may be between short-term and sentimental or other reasons long-term debt. Once for not disposing of the working capital has disap- assets. At times, the appre- peared, it is often difficult or ciation potential of the assets impossible to make changes. may appear to be large. However, the sale of unpro- Refinancing is a possible ductive assets and using the solution where a shortage of proceeds to pay off debt is an working capital and/or short- excellent way to reduce debt term debt repayment without reducing income. capacity are major problems, and equity exists in long- Selling productive assets and term assets such as land. reducing size of the business is However, this can become a a difficult approach. This dangerous habit and can be alternative is an attempt to lethal unless the underlying salvage the business by production management or selling off part of the income- financial management producing assets and applying problems are found and the proceeds to debt. One corrected. Some lenders view intent is reduction of the refinancing as the first step required interest and princi- toward business liquidation. pal payments. However, selling some productive assets Obtaining lower interest rates is sometimes is not feasible easier said than done. without liquidating the However, in some cases it is entire business. The process possible to obtain Farmers of scaling back can create Home Administration problems in matching financing at lower rates than machinery and the remaining offered by other lenders. This land. Machinery may need to possibility varies from one be down-sized or used to year to another depending on generate additional income FmHA policy. Sometimes it through custom operation. is possible to renegotiate Thus, the entire process terms of land contracts, requires careful planning. particularly if the land was The crucial phase of this purchased from a relative. If planning is to be sure that land contracts are altered, it expenses are cut back more will be necessary to seek help than income as a result of the from a qualified tax account- partial liquidation of business ant because the change in assets. the land contract may result in income tax consequences. Selling unproductive assets may help on some farm operations with assets that are currently not generating cash income. 20
  • 21. Summary Farm business analysis is the Budgets are used to organize redirecting the use of process of retrieving, organiz- information (receipts, resources to other, poten- ing, processing, and compar- expenses, resource use) about tially more profitable, uses. ing financial information the enterprises that may be from a farm business. The produced by the business. process is directed at provid- The balance sheet provides a ing the manager the informa- listing of assets and liabilities tion needed to make deci- of the business. The income sions regarding organization statement converts cash flow and operation of the farm into business earnings for the business. period under consideration, usually a calendar year. And A farm business analysis may cash flow indicates the flow involve the whole farm or of funds into and from the one enterprise. The analysis business. Analysis of informa- may be completed using tion from these documents comparative analysis, ratio helps the manager to analysis, or projected determine financial health of analysis. The latter is the business and to select typically used with cash flow changes in operations or or the income statement as organizational structure. an estimate of future business performance. Several early warning signs may be detected from the Three questions can be used farm business analysis. These to outline the process of farm include accounts payable business analysis. They are: increasing, a shortage of where are we? Where do we working capital, and failure want to be? And how do we of earnings to grow from year get there? to year. These early warning signs usually point to an The questions imply that earnings problem, the issue farm business analysis on which the manager should involves reviewing current focus attention. resources and the current operating plan, setting goals, If poor performance is the considering alternatives, and cause of the earnings deciding how to move the problem, the manager must business from where it is to select a course of action to where the operator wants it deal with the poor perform- to be. ance. These may include doing a better job of what is The tools of farm business currently being done, doing analysis include budgets, the more (or less) of what is now balance sheet, the income being done, or liquidating statement, and cash flow. the farm business and 21
  • 22. Prepared by Larry C. Jenkins, associate professor of agricul- tural economics and rural sociology Where trade names appear, no discrimination is intended, and no endorsement by the Cooperative Extension Service is implied. Issued in furtherance of Cooperative Extension Work, Acts of Congress May 8 and June 30, 1914, in cooperation with the U.S. Department of Agriculture and the Pennsylvania Legislature. J. L. Starling, Director of Cooperative Extension, The Pennsylvania State University. This publication is available in alternative media on request. The Pennsylvania State University is committed to the policy that all persons shall have equal access to programs, facilities, admission, and employment without regard to personal characteristics not related to ability, performance, or qualifications as determined by University policy or by state or federal authorities. The Pennsylva- nia State University does not discriminate against any person because of age, ancestry, color, disability or handicap, national origin, race, religious creed, sex, sexual orientation, or veteran status. Direct all inquiries regarding the nondiscrimination policy to the Affirmative Action Director, The Pennsylvania State University, 201 Willard Building, University Park, PA 16802-2801; tel. (814) 863- 0471; TDD (814) 865-3175. File No. IVE1m R2.5M296ps 22