Fearless Farm Finances…… Organizing basic financial information: balance sheet, income statement, understanding cash flows… Craig Chase, Field Specialist Farm & Ag Business Management

Plan for this session Four reasons to develop a balance sheet, an income statement, and a statement of cash flows: We are going to cover these four reasons in our allotted time today. However, we are going to work toward those reasons by asking and then answering common questions I hear from producers and comments I hear from lenders and financial analysts…

Reason #1 How is your farm doing financially? How much of your farm do you own? How much money are you actually making farming?

Financial Condition and Profitability Financial condition can be shown by the balance sheet (pp. 89-100). Profitability can be illustrated by the income statement (pp. 101-109). Understanding how cash comes in and out of the business can be illustrated by the cash flow statement (pp. 110-120).

Balance Sheet, as of 12/31/2012 Assets Liabilities Current Assets Cash 15,000 Prepaid expenses 10,000 Accounts receivable 1,000 Supplies 6,000 Int/Long Term Assets Machinery/equip 83,000 Real estate 140,000 Buildings/improve 35,000 Total Assets $290,000 Liabilities Current Liabilities Operating loan 10,000 Accounts payable 2,000 Current L/T debt 12,000 Int/Long Term Liabilities Mach/equip loans 64,000 Real estate loans 82,000 Total liabilities 176,000 Net worth 114,000 Total Liab/Net Worth $290,000

Income Statement; Yr ending 12/31/2012 Sale of crops $140,000 Other income 4,000 Gross Income 144,000 Car and truck, gas and oil, repairs 12,200 Depreciation 36,000 Fertilizer, Seed, Crop Inputs 19,800 Insurance, interest, repairs, taxes 18,400 Labor 24,600 Supplies 8,000 Utilities 8,000 Total Expenses $127,000 Net Income $ 17,000

Answers Did you make any money? How much of your farm do you own? Net income of $17,000 Net income plus depreciation of $53,000 How much of your farm do you own? Net worth of $114,000 What do you think about these numbers? What if the farm is 20 vegetable acres? What if the farm is 10 vegetable acres?

Limitations Balance sheet illustrates what is owned and owed at one point in time. Income statement presents what was made over one time period. Profitability and financial condition give you limited information regarding details of the farm.

Limitations Size (scale) of farm affects how the results are interpreted. Neither statement identifies potential problems with cash flow (pp. 110-120).

Exercises 1 and 2 Take 10 minutes answering exercises 1 and 2 related to developing an income statement and balance sheet.

Balance Sheet, as of 12/31/2012 Assets Liabilities Current Assets Cash 2,000 Supplies 1,500 Int/Long Term Assets Machinery/equip 8,500 Real estate 25,000 Buildings/improve 6,000 Total Assets $43,000 Liabilities Current Liabilities Current L/T debt 2,000 Int/Long Term Liabilities Real estate loans 12,000 Total liabilities 14,000 Net worth 29,000 Total Liab/Net Worth $43,000

Income Statement; Yr ending 12/31/2012 Sale of shares $37,500 Other income (misc sales) 4,000 Gross Income 41,500 Direct cash operating expenses 25,000 Indirect cash operating expenses 5,000 Depreciation 4,500 Total Expenses $34,500 Net Income $7,000

Reason #2 How does your farm compare to other farms? What are the strengths and weaknesses of your farm? What could you do different to be more profitable?

Benchmarking Benchmarking refers to comparing your numbers to other farms similar to yours. For example, if your cost to produce your crops or livestock are high compared to others, then your budget should be evaluated carefully to determine where the costs are different and why. Developing and understanding financial ratios is an excellent way to track your financial progress (pp. 122-138).

Comparing Financials – A few ratios Your farm Current ratio 2.6 Debt-to-asset 21% Operating profit ratio 1% Asset turnover ratio 28% Operating expense ratio 76% Net income ratio 5% Benchmark 2.24 39% 26% 38% 59% 25%

Comparing Financials What are the strengths? What are the weaknesses? Balance sheet is strong – current ratio and debt-to-asset. What are the weaknesses? Operating profit ratio, operating expense ratio, and net income ratio. What could be done differently? Evaluate operating expenses. Probably could make product mix and production changes. Evaluate revenue compared to expenses.

Limitations Whole farm analysis can only tell you in general where your strengths and weaknesses are. Your operating expenses are too high, your overall production is too low. Works very well for simple farming operations (few enterprises). Financial ratios give you a limited view of your farm - what specific management decisions can be made?

Exercises 3 Take 10 minutes answering exercise 3 related to developing ratios for your income statement and balance sheet.

Exercise 3 - Ratios 1. Current ratio 2. Debt-to-asset ratio Ans. 1.75 ($3,500 / $2,000)  2. Debt-to-asset ratio Ans. 32% ($14,000 / $43,000)  3. Operating profit ratio Ans. -10.4% (($7,000 + $700 – $12,000) / $41,500)

Exercise 3 - Ratios 4. Asset turnover ratio 5. Operating expense ratio Ans. 96.5% ($41,500 / $43,000) 5. Operating expense ratio Ans. 70.6% ($41,500 – $7,000 – $700 - $4,500) / $41,500  6. Net income ratio Ans. 16.9% ($7,000 / $41,500)

Ratios Keep in mind there are 21 commonly-used farm financial ratios that can be used to evaluate your farm. Each has its place. For example when looking at increasing your debt (through a farm investment), you would want to analyze your term debt coverage ratios to determine how much debt your farming business can handle without increasing financial risk.

Reason #3 How much money can you borrow? What will a lender think of your idea? What information should you pull together to show your lender?

Risk Rating Scale All lenders have a risk rating scale… Components of that scale may include: Ability to service (pay-off) debt Net worth trend (positive or negative) Current ratio Debt-to-asset or equity-to-asset ratio Character Management ability Collateral Payment history (credit report) Length of relationship with lender

Risk Rating Scale Each component is weighted. Ask your lender what goes into his/her scale. Know what your numbers are that he/she uses.

A Tale of Two Farms… Farm A Debt service 5 Net worth change 5 Current ratio 4 Equity-to-asset ratio 4 Character 5 Management ability 5 Collateral 5 Payment history 5 Relationship 5 Weighted Average Score 96 “Premium” Farm B Debt service 4 Net worth change 3 Current ratio 1 Equity-to-asset ratio 3 Character 3 Management ability 3 Collateral 5 Payment history 4 Relationship 4 Weighted Average Score 72 “Average”

Answers – It Depends… If you are a “Premium” it is much easier to find a lender and get a better deal. If your lender knows something about your business, is willing to actively learn, and make a farm visit at least once per year. If you come prepared (financials completed), know financial terms, and ask questions about borrowing options. If you find out what you need to do to get a better deal – shop around.

Cash Flow Statement Cash flow statement is often the forgotten statement. Question to be answered is: is there enough cash flowing into your business to cover the expenses occurred by your business? If not, then what are you going to do about it? Remember that profitability and cash flow are not the same thing – you can be profitable and have a negative cash flow and vice versa (p. 112).

Cash Flow Statement Turn to page 114 of the Fearless Farm Finances book… Three sections: Cash flow from operations Cash flow from investing Cash flow from financing

Cash Flow Statement How did Otto do? How did this year compare to earlier years and to the cash flow budget developed at the beginning of the year (cash flow budget is different)? Why would this be important? Did Otto replace the right amount of capital or did he intentionally not invest because it would put him in a negative cash flow?

Summary Income statements and balance sheets can make your decisions much easier. Cash flow statement indicates whether your farm is bringing in more cash than expending. They can also point to both strengths and weaknesses in your farm.

Summary Step 1 – A few ratios You start with a few ratios… Current ratio 2.6 good Debt-to-asset 21% good Operating profit ratio 1% low Asset turnover ratio 28% low Operating expense ratio 76% high Net income ratio 5% low You decide to see if you can lower your expenses and raise your revenues to improve your ratios related to the income statement.

Summary Spend the time to pull together some financial numbers; it will likely be the best investment you have ever made. Spend time understanding your numbers and looking at possible improvements (we all have strengths and weaknesses). Always keep in mind your financial farm goal and your questions and work through your records to find your answers…

And the Fourth Reason…. Taxes… But don’t make management decisions solely on tax management. Make them because it is a good business decision and it will lead you toward your overall income goal.

Last Thoughts… You should develop an annual budget for your farm and then monitor it (pp. 199-218). You should go over factors to improve profits (pp. 139-144) for ideas on how to improve your profitability.

Thank You for This Opportunity! Questions….. Any questions or comments? Thank You for This Opportunity! Craig A. Chase Marketing Food System Initiative Program Leader Iowa State Local Food and Farm Program Coordinator Farm Management – Local Food Systems and Alternative Enterprises 209 Curtiss Hall Iowa State University Ames, IA 50011 (515) 294-1854 cchase@iastate.edu http://www.extension.iastate.edu/agdm/fieldstaff/cchase.html