Farm Balance Sheet Analysis


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Farm Balance Sheet Analysis

  1. 1. Farm Balance Sheet Analysis AAE 320 Paul D. Mitchell
  2. 2. Goal <ul><li>Overview accounting balance sheet as it pertains to agricultural operations </li></ul><ul><li>How to prepare and/or read one </li></ul><ul><li>How to use one (financial ratios) </li></ul>
  3. 3. Balance Sheet <ul><li>Systematic listing of everything owned and owed by a business/individual </li></ul><ul><li>Gives statement of owner equity at a point in time </li></ul><ul><li>Typically for end of accounting period, such as end of year for taxes </li></ul><ul><li>Interim balance sheets often used/needed for loan applications </li></ul>
  4. 4. Balance Sheet <ul><li>Balance sheet: Everything must balance </li></ul><ul><li>Asset: anything owned </li></ul><ul><li>Liability: debt or financial obligation owed </li></ul><ul><li>The Basic Accounting Identity must hold </li></ul><ul><li>Assets = Liabilities + Owner Equity </li></ul><ul><li>Owner Equity = Assets – Liabilities </li></ul><ul><li>Equity is what’s left, the residual </li></ul>
  5. 5. Uses of Balance Sheet <ul><li>Measures financial position of firm, focusing on long and short run measures </li></ul><ul><li>Solvency : measures relative relationships among assets, liabilities and equity to assess “health” of firm (financial ratios) </li></ul><ul><li>Liquidity : measures ability to meet current financial obligations as they come due without disrupting normal business—ability to generate cash on short-term </li></ul>
  6. 6. Balance Sheet Format $250 Total Liability and Equity $250 Total Assets $100 Owner Equity $100 Non-Current Liabilities $150 Non-Current Assets $50 Current Liabilities $100 Current Assets Liabilities Assets
  7. 7. Assets <ul><li>Anything the firm owns that has value because can sell it and/or use it to produce sellable goods </li></ul><ul><li>Liquid assets: easy to sell, ready market for them (grain, feeder livestock) </li></ul><ul><li>Illiquid assets: hard to sell quickly at full value (machinery, land, breeding livestock) </li></ul>
  8. 8. Assets on Balance Sheet <ul><li>Current Assets </li></ul><ul><ul><li>Cash, bank accounts, marketable funds, accounts receivable (money owed to you), inventories of liquid assets: grain, feed, supplies, feeder livestock </li></ul></ul><ul><li>Non-Current Assets </li></ul><ul><ul><li>Everything else: machinery, equipment, breeding livestock, buildings, land </li></ul></ul>
  9. 9. Liabilities on Balance Sheet <ul><li>Obligations or debts owed; any outside claims against one or more of your assets </li></ul><ul><li>Current Liabilities </li></ul><ul><ul><li>Financial obligations due within 1 year </li></ul></ul><ul><ul><li>Accounts at suppliers, farm store, etc. </li></ul></ul><ul><ul><li>Interest & principle on operating and long-term loans </li></ul></ul><ul><ul><li>Accrued expenses: property and income taxes </li></ul></ul><ul><li>Non-Current Liabilities </li></ul><ul><ul><li>Everything else not due in the next year </li></ul></ul><ul><ul><li>Remaining balance on long-term debts after deducting the current year’s payments </li></ul></ul>
  10. 10. Alternative Balance Sheet Formats <ul><li>Traditional farm balance sheets used other categories, but use decreasing </li></ul><ul><li>Intermediate Asset: less liquid with life 1 to 10 years (machinery, equipment, perennial crops, breeding livestock) </li></ul><ul><li>Fixed Asset: > 10 year life: land, buildings </li></ul><ul><li>Intermediate Liability: 1 – 10 year loans </li></ul><ul><li>Long-term Liabilities: > 10 year loans </li></ul>
  11. 11. Owner Equity = Net Worth <ul><li>Value left after assets are used to cover all liabilities, what you “own” in the farm </li></ul><ul><li>Your current investment in the farm </li></ul><ul><li>Equity changes for many reasons </li></ul><ul><ul><li>Profits/losses from production activities </li></ul></ul><ul><ul><li>Sell assets for different values than on sheet </li></ul></ul><ul><ul><li>Add/withdraw capital from the farm </li></ul></ul><ul><ul><li>Asset value changes if use market prices for asset valuation, e.g., land value increases </li></ul></ul>
  12. 12. Owner Equity = Net Worth <ul><li>Business transactions only change the mix of assets/liabilities, not owner equity </li></ul><ul><li>Buying a $10,000 piece of machinery does not change your equity </li></ul><ul><ul><li>If cash purchase, current assets drop $10,000 and non-current assets increase $10,000 </li></ul></ul><ul><ul><li>If borrow $10,000, liability increases $10,000 and non-current assets increase $10,000 </li></ul></ul><ul><li>Equity only changes due to business profit/loss, if you put money in/pull it out, and/or (in some cases) if asset values change </li></ul>
  13. 13. Asset Valuation Problem <ul><li>How do you value assets when developing a balance sheet, Cost or Market Basis </li></ul><ul><li>Basic accounting says use cost basis, but not always right in agriculture </li></ul><ul><li>Cost Basis: value = purchase cost minus depreciation, or = farm production cost </li></ul><ul><li>Market Basis: value = current market value minus selling costs </li></ul>
  14. 14. Market Basis <ul><li>Assets valued at current market value minus selling costs </li></ul><ul><li>Asset value (and so your equity) responds to inflation and price changes, so often gives higher values (and so higher equity) </li></ul><ul><li>Asset price changes can hide management problems because equity increasing </li></ul><ul><li>Main Advantage: more accurate measure of current financial health and collateral available for loans, so often used by lenders </li></ul><ul><li>Lenders’ needs influence farm balance sheets </li></ul>
  15. 15. Cost Basis <ul><li>Asset value = purchase cost minus depreciation, or cost to produce the asset </li></ul><ul><li>More conservative, following accepted accounting practices in other businesses </li></ul><ul><li>Equity changes only from retained earnings, not from asset price changes </li></ul><ul><li>Can misrepresent true value of business </li></ul>
  16. 16. Farm Financial Standard Committee <ul><li>Recommends using both methods </li></ul><ul><li>1) Market basis balance sheet with cost basis asset values in attached schedules or in footnotes </li></ul><ul><li>2) Double Column balance sheet for assets, with market basis and cost basis </li></ul><ul><li>Measure true value market of your business and identify possible management problems </li></ul>
  17. 17. Both Methods use Both Methods Market Cost Machinery, equipment, buildings, land Market Cost or Base Value Raised breeding livestock Market Cost Purchased breeding livestock Cost Cost Investment in crops growing in the field Cost Cost Prepaid Expenses Cost Cost Accounts Receivable Market Min of Cost and Market Purchased grain and feeder livestock Market Market Raised grain and feeder livestock Market Basis Cost Basis Asset
  18. 18. Grain/Livestock Inventories and Crops in the Fields <ul><li>Grain in the bin, animals on the lot ready to go, use market basis </li></ul><ul><ul><li>Exception: Purchased grain/livestock that has gone up in value, use cost if on a cost basis </li></ul></ul><ul><li>Crops still growing in the field, use cost, since still subject to production risks </li></ul><ul><ul><li>“ Don’t count your chickens before the eggs hatch” </li></ul></ul>
  19. 19. Raised Breeding Livestock <ul><li>Cost basis: supposed to accumulate all costs to get the animal from birth to productive age (and not include these in the income statement), then depreciate this total cost over its useful lifetime just as though purchased it at this price </li></ul><ul><li>Alternative: a fixed base value for each age/type of animal to approximate this cost and its depreciation, won’t change with asset market prices </li></ul>
  20. 20. Depreciation <ul><li>Annual loss in value of a working asset due to use, wear, aging, and technical obsolescence </li></ul><ul><li>What assets due you depreciate? </li></ul><ul><ul><li>Useful life > 1 year </li></ul></ul><ul><ul><li>Useful life can be determined (not unlimited) </li></ul></ul><ul><li>Machinery, equipment, buildings, fences, breeding livestock, perennial crops, irrigation wells, land improvements (wells, drainage) </li></ul><ul><li>Land not depreciated, as has unlimited life </li></ul>
  21. 21. Depreciation Definitions <ul><li>Cost : All costs paid for the asset, including price, taxes, delivery and installation fees, expenses to get the asset into use </li></ul><ul><li>Useful Life : Number of years you expect to use the asset in your business </li></ul><ul><li>Salvage Value : Expected market value at end of useful you assigned; zero if you will use it until worn out and has no scrap or junk value at end </li></ul>
  22. 22. Depreciation Intuition <ul><li>Want to allocate the initial cost of long term asset across the useful life you give it </li></ul><ul><li>Cost – Salvage Value is asset’s total depreciation over its Useful Life—How much do you assign to each year? </li></ul><ul><li>Several formulas make assumptions and estimate annual depreciation, none is correct for all assets in all situations </li></ul>
  23. 23. Graphics of Depreciation Time (Years) Value ($) Initial Cost Salvage Value Useful Life Total Depreciation to Allocate
  24. 24. Graphics of Depreciation Time (Years) Value ($) B A Use a mathematical formula to describe how to get from Point A to Point B Slope of the line between any two years is the annual depreciation during that year Depreciation =  Value/  t One Year  t = 1  V
  25. 25. Straight Line Depreciation <ul><li>Draws a straight line between beginning and ending values, constant depreciation each year </li></ul><ul><li>Annual Depreciation </li></ul><ul><li>= (Cost – Salvage Value)/Useful Life </li></ul><ul><li>Alternative: Express as a depreciation rate </li></ul><ul><li>Annual Depreciation </li></ul><ul><li>= (Cost – Salvage Value) x R SL </li></ul><ul><li>R SL = 1/Useful Life = Depreciation Rate </li></ul><ul><li>Example: R SL = 1/10 = 0.10 = 10% </li></ul><ul><li>10% annual depreciation rate </li></ul>
  26. 26. Straight Line Depreciation Example <ul><li>$100,000 machine, use for 6 years and expected salvage value of $40,000 </li></ul><ul><li>Annual Depreciation = </li></ul><ul><li> ($100,000 – $40,000)/6 = $10,000 </li></ul><ul><li>R SL = 1/6 = 0.167 = 16.7% </li></ul><ul><li>Annual Depreciation = </li></ul><ul><li> ($100,000 – $40,000) x 16.7% = $10,020 </li></ul>
  27. 27. Straight Line Depreciation Example Value At Year End Value At Year Start 10,000 10,000 10,000 10,000 10,000 10,000 Depreciation 40,000 50,000 6 50,000 60,000 5 60,000 70,000 4 70,000 80,000 3 80,000 90,000 2 90,000 100,000 1 Ending Basis Beginning Basis Year
  28. 29. Sum of the Year’s Digits <ul><li>Annual Depreciation = </li></ul><ul><li>(Cost – Salvage Value) x RUL/SOYD </li></ul><ul><li>RUL = Remaining Useful Life at START of year </li></ul><ul><li>SOYD = sum of the year’s digits from 1 to Useful Life </li></ul><ul><li>Example: Useful Life = 6 years, then </li></ul><ul><li>SOYD = 1 + 2 + 3 + 4 + 5 + 6 = 21 </li></ul><ul><li>SOYD = n(n +1)/2, where n = Useful Life </li></ul><ul><li>Largest depreciation in first year, constant decrease in depreciation for each year after that </li></ul>
  29. 30. Sum of the Year’s Digits Depreciation Example <ul><li>$100,000 machine, use for 6 years and expected salvage value of $40,000 </li></ul><ul><li>SOYD’s = 1 + 2 + 3 + 4 + 5 + 6 = 21 </li></ul><ul><li>Annual Depreciation = </li></ul><ul><li> (Cost – Salvage Value) x RUL/SOYD </li></ul><ul><li>1 st Year (RUL at start = 6) </li></ul><ul><li>($100,000 – $40,000) x (6 – 0)/21 = $17,143 </li></ul><ul><li>2 nd Year (RUL at start = 5) </li></ul><ul><li>($100,000 – $40,000) x (6 – 1)/21 = $14,286 </li></ul>
  30. 31. SOYD Depreciation Example (100,000 – 40,000) x (6 – 5)/21 = 2,857 6 (100,000 – 40,000) x (6 – 4)/21 = 5,714 5 (100,000 – 40,000) x (6 – 3)/21 = 8,571 4 (100,000 – 40,000) x (6 – 2)/21 = 11,429 3 (100,000 – 40,000) x (6 – 1)/21 = 14,286 2 (100,000 – 40,000) x (6 – 0)/21 = 17,143 1 Depreciation Year
  31. 32. SOYD Depreciation Example 40,000 2,857 42,857 6 42,857 5,714 48,571 5 48,571 8,571 57,143 4 57,143 11,429 68,571 3 68,571 14,286 82,857 2 82,857 17,143 100,000 1 Ending Basis Depreciation Beginning Basis Year
  32. 34. Think Break #12 <ul><li>You buy a piece of equipment for $7000 with a useful life of 3 years and expected salvage value of $1000 </li></ul><ul><li>1) What is the Straight Line depreciation for the second year? </li></ul><ul><li>2) What is the Sum of the Year’s Digits depreciation for the second year? </li></ul>
  33. 35. Declining balance <ul><li>Depreciation = constant percentage of the asset’s current basis </li></ul><ul><ul><li>Not (cost – salvage value) </li></ul></ul><ul><li>Depreciation = Beginning Basis x R DB </li></ul><ul><li>R DB = Declining Balance Depreciation Rate </li></ul><ul><li>Declining Balance: $ value of depreciation decreases each year, though constant % depreciation rate </li></ul>
  34. 36. Declining Balance <ul><li>Declining Balance Depreciation Rate R DB usually a multiple of the Straight Line Depreciation Rate R SL = 1/Useful Life </li></ul><ul><li>R DB = 2 x R SL , is Double Declining Balance or 200% Declining Balance </li></ul><ul><li>Also see 1.75/175%, 1.50/150% and 1.25/125% declining balance </li></ul><ul><li>Depreciation for taxes uses declining balance </li></ul>
  35. 37. Double Declining Balance Example <ul><li>$100,000 machine, use for 6 years and expected salvage value of $40,000 </li></ul><ul><li>Double Declining Balance depreciation rate </li></ul><ul><ul><li>R SL = 1/6 = 16.67% </li></ul></ul><ul><ul><li>R DB = 2 x R SL = 2/6 = 2 x 16.67% = 33.3% </li></ul></ul><ul><li>1 st Year DDB Depreciation is </li></ul><ul><li>$100,000 x 1/3 = $33,333 </li></ul>
  36. 38. Double Declining Balance Example 4,390 6,584 9,877 14,815 22,222 33,333 Depreciation Ending Basis Calculation Beginning Basis Year 8,779 13,169 x 33% 13,169 6 13,169 19,753 x 33% 19,753 5 19,753 29,630 x 33% 29,630 4 29,630 44,444 x 33% 44,444 3 44,444 66,667 x 33% 66,667 2 66,667 100,000 x 33% 100,000 1
  37. 39. Double Declining Balance Example Problem: Basis can fall below salvage value Ending Basis Depreciation Beginning Basis Year 8,779 4,390 13,169 6 13,169 6,584 19,753 5 19,753 9,877 29,630 4 29,630 14,815 44,444 3 44,444 22,222 66,667 2 66,667 33,333 100,000 1
  38. 40. Potential Problems with Double Declining Balance <ul><li>Assets with positive salvage value, basis can fall below salvage value </li></ul><ul><ul><li>Stop depreciation at salvage value </li></ul></ul><ul><li>Assets with zero salvage value, basis never reaches zero </li></ul><ul><ul><li>Switch to straight line after some set time </li></ul></ul><ul><ul><li>Take remaining value in last year </li></ul></ul>
  39. 41. Double Declining Balance Example (Salvage value = $40,000) Ending Basis Depreciation Beginning Basis Year 40,000 0 40,000 6 40,000 0 40,000 5 40,000 0 40,000 4 40,000 4,444 44,444 3 44,444 22,222 66,667 2 66,667 33,333 100,000 1
  40. 43. Compare the Three <ul><li>Straight Line Depreciation </li></ul><ul><ul><li>Slowest depreciation; Finishes at the salvage value without any adjustments </li></ul></ul><ul><li>Sum of the Year’s Digits </li></ul><ul><ul><li>Medium rate of depreciation; Finishes at the salvage value without any adjustments </li></ul></ul><ul><li>Declining Balance </li></ul><ul><ul><li>Typically fastest (specially DDB); Often has to be adjusted to finish at the salvage value </li></ul></ul>
  41. 44. Depreciation Graphics
  42. 45. Asset Value Graphics
  43. 46. Think Break #13 <ul><li>Machine costs $7000 with a useful life of 3 years and salvage value of $1000 </li></ul><ul><li>1) What is the double declining balance depreciation for the 1 st year? </li></ul><ul><li>2) What is machine’s ending basis in 1 st year? </li></ul><ul><li>3) What is the double declining balance depreciation for the 2 nd year? </li></ul><ul><li>4) What is machine’s ending basis in 2 nd year? </li></ul>
  44. 47. Depreciation and Taxes <ul><li>US tax code has rules and options for depreciating business assets, including those used by farmers </li></ul><ul><li>MACRS: Modified Accelerated Cost Recovery System </li></ul><ul><li>Three methods used: 200% DB, 150% DB, and Straight Line </li></ul><ul><ul><li>Depends on asset type </li></ul></ul><ul><ul><li>Sometime you get to choose </li></ul></ul>
  45. 48. Depreciation and Taxes <ul><li>Determine asset’s basis (called tax basis) </li></ul><ul><ul><li>Basis adjusted for several reasons, such as improvements made, damage, etc. </li></ul></ul><ul><li>Calculate depreciation as a % of tax basis </li></ul><ul><ul><li>% taken from a table </li></ul></ul><ul><ul><li>Tax tables assume zero salvage value </li></ul></ul><ul><li>Deduct depreciation from your taxable income (so you pay lower taxes!) </li></ul><ul><li>Tax basis ≠ true value or your book value </li></ul>
  46. 49. Depreciation and Taxes <ul><li>Section 179: Allows taking a large amount of depreciation in year purchase asset </li></ul><ul><ul><li>Way to really reduce income (and so taxes) </li></ul></ul><ul><ul><li>Buy equipment/building and write full cost off as a cost of business in that year </li></ul></ul><ul><ul><li>The ending basis of asset is zero in first year </li></ul></ul><ul><li>Many farmers do this in years they make more money than usual </li></ul>
  47. 50. Depreciation and Taxes <ul><li>Depreciation Recapture: Form 4797 </li></ul><ul><li>When sell an asset, if the sales price differs from the tax basis, file Form 4797 </li></ul><ul><li>If sale price > tax basis: claim extra as ordinary income and pay income taxes </li></ul><ul><li>If sale price < tax basis: claim extra depreciation and reduce ordinary income and income taxes </li></ul><ul><li>Eventually the government gets its taxes if you “over depreciate” an asset via Section 179 </li></ul>
  48. 51. Depreciation and Taxes <ul><li>Main Point: Tax depreciation not the same as “real” depreciation </li></ul><ul><ul><li>Section 179 depreciation really throws it off </li></ul></ul><ul><li>Businesses & farms: some keep separate records </li></ul><ul><ul><li>Tax depreciation and tax basis records </li></ul></ul><ul><ul><li>Book value for farm balance sheet for farm’s “real” value for loan applications </li></ul></ul><ul><ul><li>Records of asset values for insurance purposes </li></ul></ul><ul><ul><li>Can create complicated farm records </li></ul></ul>
  49. 52. Summary Thus Far <ul><li>Explained concept of a balance sheet </li></ul><ul><ul><li>Current and Non-current Assets </li></ul></ul><ul><ul><li>Current and Non-current Liabilities </li></ul></ul><ul><ul><li>Equity: what balances the sheet </li></ul></ul><ul><li>How value Assets: cost or market basis </li></ul><ul><li>How depreciate assets: straight line, sum of year’s digits, double declining balance </li></ul><ul><li>Taxes and depreciation </li></ul><ul><li>What do you do with a balance sheet?????? </li></ul>
  50. 53. What use is a Balance Sheet? <ul><li>Can see where assets and liabilities are and their relative sizes </li></ul><ul><li>Can look at changes if have balance sheets from previous years—see if you’re gaining </li></ul><ul><li>Typically focus on ratios to look at Liquidity and Solvency of the business </li></ul><ul><li>Ratios control for differences in business size </li></ul>
  51. 54. Current Ratio and Liquidity <ul><li>Measures ability to meet current financial obligations as they come due without disrupting normal business—ability to generate cash on short-term </li></ul><ul><li>Current Ratio = </li></ul><ul><li>Current Assets/Current Liabilities </li></ul><ul><li>Example: 1.4 or 40% </li></ul>
  52. 55. Current Ratio <ul><li>Too low: cash flow problems, if asset prices change or costs suddenly arise (repairs), can have trouble meeting current liabilities </li></ul><ul><ul><li>Don’t want to sell 10 acres to put new roof on barn </li></ul></ul><ul><li>Too high: holding too much cash, current assets typically have lower return than if put capital into other longer term assets or market </li></ul><ul><ul><li>Income lost by keeping cash “under the mattress” </li></ul></ul><ul><ul><li>Parable of the talents: buried gold in ground </li></ul></ul>
  53. 56. What are typical current ratios? <ul><li>IL Farm Business Farm Management Program of 2,166 IL farms in 1996 </li></ul><ul><li>Fairly typical by farm types </li></ul><ul><li>Farm Type Median Current Ratio </li></ul><ul><li>Hogs 2.03 </li></ul><ul><li>Grain 1.81 </li></ul><ul><li>Beef 1.57 </li></ul><ul><li>Dairy 1.33 </li></ul>
  54. 57. What’s a good Current Ratio? <ul><li>Iowa State University Extension : </li></ul><ul><ul><li>Typically farms with adequate liquidity have current ratios > 2.0 </li></ul></ul><ul><ul><li>Farms with continuous sales (dairy) often have current ratio as low as 1.5 </li></ul></ul><ul><ul><li>Beef feeding farms have low current ratios </li></ul></ul><ul><ul><li>Farms with concentrated sales (cash grain) need current ratio as high as 3.0 early in year </li></ul></ul><ul><li>Ohio State University Extension : Measures of Dairy Farm Competitiveness: 1.3 is competitive </li></ul>
  55. 58. Working Capital vs Current Ratio <ul><li>“ Working Capital” older term used by some </li></ul><ul><li>Working Capital = </li></ul><ul><li>Current Assets – Current Liabilities </li></ul><ul><li>Measures the margin of safety in dollars (not ratio or %) to meet short-term liabilities </li></ul><ul><li>Must relate it to size of business, that’s why we use current ratio! </li></ul><ul><ul><li>$10,000 not much for a 5000 acre farm, but may be more than enough for a 20 cow dairy </li></ul></ul><ul><li>This why most use current ratio </li></ul>
  56. 59. Solvency <ul><li>Measures relative relationships among assets, liabilities, and equity to assess “health” of firm </li></ul><ul><li>Could the farm debt be paid off if foreclosed? </li></ul><ul><li>Requires Assets > Liabilities </li></ul><ul><li>Measured by three ratios </li></ul><ul><ul><li>Debt to Asset Ratio </li></ul></ul><ul><ul><li>Equity to Asset Ratio </li></ul></ul><ul><ul><li>Debt to Equity Ratio </li></ul></ul><ul><li>Given any one ratio, you can derive the others, so each is a different way to look at Solvency </li></ul>
  57. 60. Debt to Asset Ratio <ul><li>Debt/Asset = Total Liabilities/Total Assets </li></ul><ul><li>Proportion (or %) of business assets owed to lenders (i.e. % the bank owns) </li></ul><ul><li>0.70 means you owe 70% of farm assets to lenders (bank owns 70%) </li></ul><ul><li>1.0 means debts = assets </li></ul><ul><ul><li>Means owner equity is zero, bank owns 100% </li></ul></ul><ul><li>> 1.0 means business is insolvent </li></ul>
  58. 61. Equity to Asset Ratio <ul><li>Equity/Asset = Total Equity/Total Assets </li></ul><ul><li>Proportion (or %) of assets owned </li></ul><ul><li>0.45 means you own 45% of farm </li></ul><ul><li>1.0 means equity = assets so owner has no liabilities (he/she owns all equity) </li></ul><ul><ul><li>Own 100% of the farm </li></ul></ul><ul><li>< 0 means business is insolvent—has no or negative equity </li></ul>
  59. 62. Debt to Equity Ratio <ul><li>Debt/Equity = Total Liabilities/Owner Equity </li></ul><ul><li>Proportion of financing provided by lenders relative to that provided by owner equity </li></ul><ul><li>1.0 means you and your lenders are providing equal proportion of financing </li></ul><ul><li>0.75 means for each dollar of equity financing you provide, your lender provides $0.75 of financing </li></ul><ul><li>1.8 means for each dollar of equity financing you provide, your lender provides $1.80 of financing </li></ul><ul><li>Very large Debt/Equity ratio implies very small equity and potential for insolvency </li></ul>
  60. 63. Relation between Ratios <ul><li>Given any of these three financial ratios, you can derive the others </li></ul><ul><li>Basic Accounting Identity must hold </li></ul><ul><li>Assets = Liabilities + Equity </li></ul><ul><li>Assets = Debts + Equity </li></ul><ul><li>Notation: A = D + E </li></ul><ul><ul><li>Debt/Asset = D/A </li></ul></ul><ul><ul><li>Equity/Asset = E/A </li></ul></ul><ul><ul><li>Debt/Equity = D/E </li></ul></ul>
  61. 64. <ul><li>A = D + E Divide by A: 1 = D/A + E/A </li></ul><ul><li> Debt/Asset + Equity/Asset = 1, or </li></ul><ul><li> Equity/Asset = 1 – Debt/Asset </li></ul><ul><li> Debt/Asset = 1 – Equity/Asset </li></ul><ul><li>(D/A)/(E/A) = D/E, or </li></ul><ul><li> Debt/Equity = Debt-to-Asset/Equity-to-Asset </li></ul><ul><li>Rearrange and use D/A and D/E connection </li></ul><ul><li> Debt/Asset = Debt/Equity/(1 + Debt/Equity) </li></ul><ul><li> Equity/Asset = 1/(1 + Debt/Equity) </li></ul>Relation between Ratios
  62. 65. Typical Solvency Ratios <ul><li>IL Farm Business Farm Management Program of 2,166 IL farms in 1996 </li></ul><ul><ul><li>Debt to Asset Ratios </li></ul></ul><ul><li>Farm Type upper 25% Median lower 25% </li></ul><ul><li>Hogs 0.44 0.30 0.16 </li></ul><ul><li>Grain 0.46 0.29 0.15 </li></ul><ul><li>Beef 0.52 0.31 0.17 </li></ul><ul><li>Dairy 0.50 0.36 0.23 </li></ul>
  63. 66. WI Center for Dairy Profitability WI Dairy Balance Sheet for 2000 111.6% 47.3% 52.7% > 250 95.2% 51.2% 48.8% 151-250 45.2% 68.9% 31.1% 101-150 40.8% 71.0% 29.0% 76-100 32.1% 75.7% 24.3% 51-75 29.6% 77.2% 22.8% < 50 Debt/Equity Equity/Asset Debt/Asset Size (cows)
  64. 67. More Information <ul><li>Provide a quick list/overview of what sort of information is available on farm finance </li></ul><ul><li>Farm Financial Standards Council </li></ul><ul><li>University Extension: UW and other states </li></ul><ul><li>UW Center for Dairy Profitability </li></ul>
  65. 68. Farm Financial Standards Council <ul><li>Home page: </li></ul><ul><li>Mission: “To provide education and a national forum to facilitate the development, review, communication and promotion of uniformity and integrity in both financial reporting and the analytic techniques useful for effective and realistic measurement of the financial position and the financial performance of agricultural producers.” </li></ul><ul><li>Financial Guidelines for Agricultural Producers </li></ul><ul><li> </li></ul><ul><li>Recommendations of how to prepare Farm Financial Balance Sheet with several examples </li></ul><ul><li>The source for this sort of information </li></ul>
  66. 69. UW-Extension <ul><li>Bruce Jones (AAE, UW-Madison) Focuses on dairy farm management and land valuation </li></ul><ul><li>See his home page for most recent papers and presentations: </li></ul><ul><li>Gregg Hadley (Ag Econ, UW-Riverfalls) focuses on dairy farm management profitability and finance </li></ul><ul><li> </li></ul><ul><li>Both work with UW Center for Dairy Profitability </li></ul>
  67. 70. UW Center for Dairy Profitability <ul><li>Homepage: </li></ul><ul><li>Focuses mostly (not exclusively) on dairy </li></ul><ul><li>Lots of materials, some financial </li></ul><ul><li>WI dairy data as Farm Balance Sheets for comparison and benchmarking </li></ul><ul><li> </li></ul>
  68. 71. Neighboring States <ul><li>Center for Farm Financial Management </li></ul><ul><li>http:// / </li></ul><ul><li>Sell/Support FINPACK: “The most comprehensive computerized farm financial planning and analysis system available“ </li></ul>
  69. 72. Neighboring States <ul><li>Iowa State University: AgDecision Maker </li></ul><ul><li>http:// </li></ul><ul><li>University of Illinois: FarmDoc </li></ul><ul><li> </li></ul><ul><li>Both have sections on Farm Finance with several publications and decision aids </li></ul>
  70. 73. Non-Neighboring States <ul><li>Oklahoma State University </li></ul><ul><li>Damona Doye’s web page </li></ul><ul><li>http:// = ddoye </li></ul><ul><li>Farm Financial Management Resources </li></ul><ul><li> </li></ul><ul><li>Farm and Ranch Account Book </li></ul><ul><li> </li></ul>
  71. 74. Summary <ul><li>Explained balance sheet </li></ul><ul><ul><li>assets, liabilities, equity </li></ul></ul><ul><li>How to value Assets: cost or market basis </li></ul><ul><li>How to depreciate Assets: straight line, sum of year’s digits, declining balance </li></ul><ul><li>Ratios: Current Ratio, Debt:Asset, etc. </li></ul><ul><ul><li>How to construct and interpret </li></ul></ul><ul><ul><li>Typical values by farm type </li></ul></ul><ul><li>Where to go for more information </li></ul>