How to Analyze Farm Financial Statements
As a young, or new farmer, writing your business plan is typically a solid starting point to developing your farm's financial future. But, how do you understand the financial portion of your agribusiness? Let us guide you through three steps that can help you better comprehend your farm financials.
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WHY DO I NEED TO UNDERSTAND MY FARM FINANCES?
Before you look into each of the statements and ratios, it's important to know why keeping track of your farm finances is important - it's not just an item to check off the list. Understanding farm financials are important to make sure you're operation is efficient and profitable, remaining compliant with legal requirements for taxes and payroll purposes, and to understand your financial position for when you need a loan to grow.
1. Understanding Farm Financial Statements
INCOME STATEMENTS
A farm income statement is one of three important financial statements used for reporting a farms financial performance over a specific period of time. The income statement can also be referred to as a profit and loss statement. The statement is focuses on three key items: revenue, expenses, and the resulting profits or losses.
Net Farm Income = Income - Expenses
CASH FLOW STATEMENTS
A cash flow statement is a listing of cash (or cash equivalents) entering and leaving an operation that occurred during the past accounting period. A cash flow budget is a projection of future flows that would include expected payments or payments to accounts receivable. Think of this as a “check book registry”.
BALANCE SHEET
As lenders, we commonly utilize a farmer’s balance sheet for a financial reference. A balance sheet is a “snapshot” of a farmer’s financial position and it outlines an individual’s net worth. Net worth reflects the value or dollar amount of the reported assets you actually own, versus how much is currently financed. Balance sheets from December 31 are the most useful and coincide with taxes. Even if you aren’t requesting a loan, it’s a good idea to gauge your growth and financial position at a given point throughout the year and to keep this timing consistent from year to year. This should help you to determine both your personal and business financial position.
Want to see it explained a little easier? Check out this quick video!
Assets are what you own. Some examples of assets are cash, real estate, equipment, etc.
Liabilities are what you owe. Some examples of liabilities are credit card debt, mortgages, equipment, auto loans, etc.
2. Farm Financial Ratios & Benchmarks
Financial ratios will tell you how one particular aspect of your operation relates to another in the form of assets and liabilities. You can use these ratios to compare yourself to industry specific benchmarks to measure your performance against the competition and rest of the industry’s producers. These ratios will change over time and there is value in comparing ratios over time to assess the overall progress you are making. For example is leverage getting better or worse? Why? Likewise, depending on what industry you are involved with these benchmarks could change, making internal benchmarking important.
Your current assets are typically balance sheet items that are reasonably expected to be converted to cash within one year in the normal course of your farm business. These are typically feed, seed, crops held for resale, market livestock and accounts receivable.
Your current liabilities are farm debts that are due within one year. These are expenses such as the current portion of term debt for the operation, cash rent, credit card debt, and accounts payable for seed, feed or fertilizer.
LIQUIDITY
What do financial benchmarks mean for your farming operation? Essentially the figure you are coming up with tells you how much of the year’s expenses you can pay with the liquid funds available for daily operations. Keep in mind the first ratio assumes that all current liabilities (debt payments due in 12 month) are maintained and focuses primarily on the funds available for day to day operations and business expenses.
Both the current ratio and working capital ratio are measures of liquidity. Liquidity is the ability of the business to meet financial obligations as they come due. It is defined as the availability of cash or near-cash assets to cover short-term obligations without disrupting normal business operations.
What is your current ratio?
Current Ratio = Total Current Assets/Total Current Liabilities
- <1.3 – evaluate and make changes*
- Between 1.3 and 2 – monitor the situation*
- >2 – is strong financial position*
Ideally as an owner/operator you aim to have a minimum of a 1:1 ratio. Current ratio determines if we liquidate all current assets does it satisfy our current debt obligations. This ratio allows you to see that you have $X available to service every $1 of current debt.
What are ways to improve your Current Ratio? Selling capital assets that are not generating return to the business. This will allow you to use the cash to reduce current liabilities. Also, you can use any extra cash income generated by the farm to pay accounts payable or to reduce your farm operating line of credit rather than making additional principal payments on term loans. If your farm operating loan is close to the maximum principal level or if your farm has carryover operating debt from the previous year, consider refinancing some of the farm operating debt with longer term financing. Consider funding capital investments (ie: M/E) with longer term financing rather than cash.
WHAT IS WORKING CAPITAL?
Working Capital = Total Current Assets –Total Current Liabilities
Working capital is the money available to fund a business’s day-to-day operations. Positive working capital indicates the business can pay off its short-term liabilities almost immediately. For your operation, this might look like $/acre or $/cow.
A good ratio to calculate to reflect liquidity is working capital as a percentage of annual expenses.
Working Capital as a percentage of Annual Expenses = (Current Assets – Current Liabilities)/ Farm Expense.
- <20% - evaluate and make changes*
- 20%-40% - monitor the situation* The reason you would want to monitor your financials closely if you fall within this range is because this ratio tells you that you will only be able to maintain 20-50% of your annual farm expenses with the funds that you currently have available for daily operations.
- >40% - strong financial position* Depending on your industry and personal risk tolerance it can be assumed that if you fall above 50% for this ratio you are in a comfortable position because you are able to maintain over half of your annual farm expenses with the funds that you currently have available for daily operations.
*Depending on what industry you are involved with these benchmarks could change.
EQUITY
Why is equity important to your farm operation and how can you use it to drive results? Your equity position depicts the relationship between your assets (what you own) and your financial obligation (what you owe). The equity ratio helps you to evaluate the percentage you own of the assets reported on your balance sheet, versus how much of it may be financed by a lender. The basic ratio to determine percent equity is:
% Equity = Total Farm Equity / Total Farm Assets
- <40% - evaluate and make changes*
- 40%-70% - monitor the situation*
- >70% - strong financial position*
*Depending on what industry you are involved with these benchmarks could change.
PROFITABILITY
One key to long term business success is being profitable. Assessing profitability is important to the success of your business. Do you currently own assets, equipment, vehicles, or livestock that aren’t making you any money? If so, what you own these assets and is there an opportunity to put your business in a better position by using those assets in another way to potentially liquidating them? The Return on Assets (ROA) shows the percentage of how profitable a farm’s assets are in generating revenue. The ratio to determine ROA is:
ROA = (Net Income + Interest) / Total Farm Assets
- <4% - evaluate and make changes*
- 4%-8% - monitor the situation*
- >8% - strong financial position*
*Depending on what industry you are involved with these benchmarks could change and determining your internal benchmark will help to show individual business progress over time.
EFFICIENCY
To measure efficiency, the Operating Expense Ratio (OER) can be used to show the relationship between operating expenses and gross revenue. This is calculated with the following formula:
OER = Farm Expenses / Farm Receipts
- >80% - evaluate and make changes*
- 60%-80% - monitor the situation*
- <60% - strong financial position*
*Depending on what industry you are involved with these benchmarks could change.
REPAYMENT CAPACITY
Another key to long term success besides profitability of a business is positive cash flow. Is the business generating sufficient income to cover the debt service obligations? To measure repayment capacity, the Debt Coverage Ratio can be used to show the relationship between operating income and the annual principal and interest obligations of term debt and capital leases. This is calculated with the following formula:
Debt Coverage Ratio = (Net Income + Depreciation + Interest Cost + Capital Leases) / (Scheduled Annual Principal and Interest Payments on All Debt + Capital Lease Payments)
- <125% - evaluate and make changes*
- 125%-175% - monitor the situation*
- >175% - strong financial position*
Know Your Numbers
While farming is a risky business, identifying production and financial projections are an important management skill. Farmers do have resources to help determine these values. Think about it this way, what amounts should I invest in acreage to be farmed or livestock to be purchased, raised or sold? Or what amounts will I receive for the sale of farm products? Remember these are projections, do your best to make them realistic. We encourage meeting with your loan officer to help walk you through this conversation and to help interpret what the ratios and benchmarks mean to your individual operation.
As an owner-operator it is important to keep accurate financial and production records for your operation -this will enable you to calculate these projections for the future. If you need some help understanding yours and taking the next step - give us a call. We're here to help!