March 15, 2014

How to Evaluate a Capital Purchase Tools and ideas to help make a financial decision. 2

The Decision Making Model Before making a major purchase decision, ask yourself the following questions: Why do you want to make this purchase? Can you manage your operation more efficiently instead of making a capital purchase? Where is your business in its lifecycle? 3

The Decision Making Model What is the state of your industry? –Depressed, stable, or growing? How strong is your management team? – Management is an important element of your business. How does your need for financing mesh with your business plan? –If you don't have a business plan, make writing one your first priority! 4

What’s a SWOT Analysis? Tool to help you evaluate the: Strengths, Weaknesses, Opportunities, and Threats (SWOT) of your business Every member of your team should be involved in the process! 5

S.W.O.T. Strengths Weaknesses Opportunities Threats Internal  Strengths  Weaknesses External  Opportunities  Threats

S.W.O.T. For each weakness or threat, there should be an off-setting strength or opportunity to compensate. If this is not the case, then these areas need to be addressed.

Strengths Considered mostly Internal What do you and your family or management team bring to your business? 8

Strengths Examples Internal element Low-cost producer –Financial Plan Competent and reliable employees –Resource inventory Marketing niche –Marketing plan Expertise in production –Production plan & resource inventory (skills)

Weaknesses Generally considered Internal These are the factors you will need to address to run a successful business 10

Weaknesses Examples Internal element Highly leveraged –Financial plan Lack of experience in the industry –Mentor, education Not utilizing futures market –Marketing plan Inadequate facilities or machinery –Resource inventory Are there siblings fighting over family land?

Opportunities Considered mostly External What opportunities are available to your business? Advantageous choices and directions for the business. 12

Opportunities Examples External element Are there new technologies that would lower costs? Will diversification of enterprises increase profit? Can my operation command a competitive edge?

Threats Considered mostly External Threats from outside your business that will directly affect you Have very little control over them 14

Threats Examples External element Ethanol explosion to a cattle feeder Drought causing water shortage Unforeseen competition (local or foreign) Regulatory Changes

Financial and Management Benchmarks Know your financial benchmarks Equity Liquidity Efficiency Ratio Know your management benchmarks Cost of production Credit Score Risk Management Business Plan

Measurement Tools: Easy to Use Comprehensive and meaningful Accurate Appropriately calculated 17

Equity Position Total Farm Equity ÷ Total Farm Assets (Total Farm Equity is the Total of Farm Assets minus the Total of Farm Liabilities) Example: $1,000,000 (total assets) - $600,000 (total liabilities) = $400,000 (equity) $400,000 (equity) ÷ $1,000,000 (total assets) = 40% Percent Equity You own 40% of your assets 18

Liquidity Working Capital ÷ Total Expenses (Working Capital is Current Assets minus Current Liabilities) Example: $300,000 (current assets) - $200,000 (current liabilities) = $100,000 (working capital) $100,000 (working capital) ÷ $400,000 (total expenses) = 25% Liquidity 19

Efficiency Ratio Total Expenses (minus interest minus depreciation) ÷ Total Revenue Example $400,000 (Total Expenses) - $50,000 (interest & depreciation) = $350,000 (operating expenses) ÷ $500,000 (total revenue) = 70% 20

Key Ratios & Practices Guidelines Only - - These can vary by lender and/or commodity MetricGreenYellowRed Equity Position>65%35-65%<35% Liquidity>50%20-50%<20% Efficiency Ratio<70%70-80%>80% Credit Score <650 Business PlanWritten and Review Annually Partial Plan Verbalized None Know Cost of ProductionBy EnterpriseFarm Ranch Overall None Risk ManagementAll ComponentsSomeNone 21

Why “Positive Cash Flow” is So Important… 1.Provides funding for business expansion Cash from operations should support at least 25% to 40% of costs related to expansion 2.Enables discretionary equipment purchases or improvements to property and facilities 3.Creates flexibility for management decisions 4. Limits reliance on creditors

Case Study Analysis Exercise Help Tom and Jane become more confident about whether or not to make this land purchase by doing the following: Perform a SWOT analysis Complete assessment of the key financial ratios Complete assessment of management benchmarks Decide if Tom and Jane should or should not purchase the property 23

Meet the Smith Family The Smith family has operated a hay operation for over 15 years. The family withdraws about $60,000 each year for family living. The operation is located in a rural area, but urban city is close by. Tom and Jane have two children (ages 20 and 17), both whom help out on the farm and have shown interest in coming back after college. 24

Meet the Smith Family (continued) Jane works off the farm for an accountant with take home pay of $20,000 plus health, dental and other benefits that extend to the whole family. Tom completes a cash flow budget each year and Jane uses QuickBooks to input their expenses and income and reconciles each quarter. Their neighbor Sally wants to sell 50 acres (planted in corn) for a sale price of $300,000. This additional land should be able to generate a net income after all costs of $50,000 Bank financing is available for $270,000 25

Financial & Benchmarking Tom & Jane Smith Before Purchase 26 Key information from the case study is as follows: Balance SheetCurrentIncome StatementCurrent Other Information Current Assets$300,000Total Revenue$500,000 Jane's Credit Score790 Non-Current Assets$700,000Interest Expense $25,000Tom's Credit Score690 Total Assets$1,000,000Depreciation $25,000 Operating Expenses$350,000 Crop Insurance?Yes Current Liabilities$200,000Total Expenses$400,000 Hedges & Options?No Non-Current Liabilities$400,000Net Farm Income$100,000 Knows Cost of Production?Yes Total Liabilities$600,000Non-Farm Income$20,000 Business Plan?Thinking about it Family Living Expense($60,000) Net Worth$400,000Income Taxes($30,000)Debt Service$50,000 Total Net Income$30,000

Financial & Benchmarking Tom & Jane Smith After the Purchase 27 If Tom and Jane purchase the property, key financials will change as follows: Balance SheetPost PurchaseIncome StatementPost Purchase Other Information Current Assets$270,000Total Revenue$600,000 Jane's Credit Score790 Non-Current Assets$1,000,000Interest Expense $50,000Tom's Credit Score690 Total Assets$1,270,000Depreciation $25,000 Operating Expenses$375,000 Crop Insurance?Yes Current Liabilities$225,000Total Expenses$450,000 Hedges & Options?No Non-Current Liabilities$645,000Net Farm Income$150,000 Knows Cost of Production? Not by Enterprise Total Liabilities$870,000Non-Farm Income$20,000 Business Plan?Thinking about it Family Living Expense($60,000) Net Worth$400,000Income Taxes($30,000)Debt Service$100,000 Total Net Income$80,000

Your Task: Review the Equity Position Ratio Review the Liquidity Ratio Review the Efficiency Ratio Perform a SWOT Decide if Tom & Jane should purchase the property. 28

Financial Ratios Equity Position –Before Purchase 40% –After Purchase 31% Liquidity –Before Purchase 25% –After Purchase 10% Efficiency –Before Purchase 70% –After Purchase63% 29

Management Benchmarks Knows Cost of Production __________ Credit Score __________ Risk Management __________ Business Plan__________ 30

S.W.O.T Strengths (internal)Weaknesses (internal) 31

S.W.O.T Opportunities (external)Threats (external) 32

Financial & Management Benchmark Benchmark MeasureGreenYellowRedTom & Jane Before Purchase Tom & Jane After Purchase Equity Position>65%35-65%<35%40%31% Liquidity>50%20-50%<20%25%10% Efficiency Ratio<70%70-80%>80%70%63% Knows cost of Production By Enterprise OverallNone Credit Score> <650 Risk ManagementAll Components SomeNone Business PlanWrittenVerbalizedNone 33