Annie’s Project January 30, 2007 Coweta Oklahoma Financial Statements Annie’s Project January 30, 2007 Coweta Oklahoma

What are financial statements? Financial statements are the written reports on the financial condition of a business. There are three major types of financial statements.

Types of Financial Statements Balance Sheet A statement that shows the wealth of the business at a given date. Cash Flow Statement A summary of the cash inflows and outflows for a business over a given time period. Income Statement A summary of income and expenses for a business over a given time period.

Balance Sheet A balance sheet is a summary sheet of everything that is owned and owed by the operation. A balance sheet should be done at the beginning and end of each fiscal time period. A balance sheet can be done using the market value or cost basis methods.

Which Method to Use? Market Value Cost Basis Typically used by most lending institutions Easiest to determine Easiest to over or under estimate Due to rapidly changing markets, could overstate or understate net worth. Cost Basis Must have good records Must know depreciation of assets Probably gives a truer picture of the value of the business

Parts of a Balance Sheet A balance sheet has three components Assets – what is owned Current and non-current Liabilities – what is owed Net Worth – Assets minus Liabilities

Current Assets Current assets are assets that will be used up or sold during the next twelve months. Examples include: Cash, checking accounts, savings Investments Accounts receivable Prepaid expenses Cash investments in growing crops Inventories Market livestock, stored crops, purchased feed, supplies

Non-Current Assets Non-current assets are assets that have a useful life of more than 1 year. Examples include: Breeding livestock Machinery, equipment Vehicles Investments in capital leases Land Buildings and improvements

Current Liabilities Accounts payable Notes payable Current portion of term debt Accrued interest Taxes payable Deferred taxes

Non-current Liabilities Notes payable, non-real estate Notes payable, real estate Deferred taxes

Net Worth Net worth of the business is the difference between the total value of the assets and the total value of the liabilities. Net (Current Assets + Non-current Assets) Worth − (Current Liabilities + Non-current Liabilities) =

Balance Sheet Exercise

Cash Flow Statement A cash flow statement is a summary of cash inflows and outflows divided into equal time periods usually monthly. Cash Inflows Operating receipts Crop and livestock sales, government payments, other farm income Capital sales Contributed capital Cash Outflows Operating expenses (feed, fertilizer, etc.) Capital purchases Family living and other withdrawals

Uses of a Cash Flow Statement Establishes target levels for income and expenses which can be used in monitoring progress towards goals Points out potential problems in meeting financial obligations Indicates when cash is available for new investments

Cash Flow Exercise

Income Statement There are two methods of doing an income statement. Cash Cash receipts and expenses are recorded when the they are paid. Most non-cash expenses are not included. Accrual Records receipts and expenses when they occur. Inventory changes are included.

Difference Between Cash Flow and Income Statement Income statement does not include: Capital sales and contributed capital Principal payments Family living expenses Cash flow statement does not include: Depreciation

The Accrual Adjusted Income Statement Revenues Livestock and crop sales Changes in inventories Government payments & other farm income Gain/loss from sale of culled breeding stock Change in value due to change in raised breeding livestock numbers Accrual adjustments in asset accounts

Changes in Inventories Market livestock Raised crops/feed inventories

Gains/Losses on Sale of Culled Breeding Livestock Purchased breeding stock: subtract cost basis from the sale proceeds Raised breeding stock: subtract base value from the sale proceeds

Change in Value Due to Change in Raised Breeding Livestock Numbers Number of head transferring from one classification to another, e.g., replacement heifers to cows Differences in base values of the two classifications

Accrual Adjustments (Assets) Change in: Accounts receivable Prepaid expenses Cash investment in growing crops Supplies Contracts and notes receivable Investment in cooperatives

The Accrual Adjusted Income Statement Expenses Purchased market livestock Cash operating expenses Changes in feed inventories Accrual adjustments for liability accounts Depreciation Cash interest paid Change in accrued interest

Accrual Adjustments Changes in: Purchased feed inventories Accounts payable Ad valorem taxes Employee payroll withholdings Accrued expenses Accrued interest

Depreciation There are different methods of depreciation. Modified Accelerated Cost Recovery System (MACRS) General Depreciation System (GDS) Alternative Depreciation System (ADS) Which one depends type of property Straight Line Depreciation Cost – Salvage Value Years of Life

The Accrual Adjusted Income Statement Net Farm Income, Accrual Adjusted = Gross Farm Revenues - Total Operating Expenses - Total Interest Expense +/- Gain/Loss on Sale of Farm Capital Assets

Gains/Losses on Sale of Farm Capital Assets Difference between the value for which the items is sold and the adjusted basis (cost minus depreciation taken)

Look at an Income Statement

Measuring Financial Stress Liquidity Ability to pay bills as they come due and cover unanticipated events Solvency Ability to cover all debts if the business were sold Profitability Returns to labor and management generated by the operation Financial efficiency Efficiency with which assets generate income Repayment capacity Ability to repay term debt in a timely fashion

Measuring Liquidity Current ratio = Total current farm assets Total current farm liabilities Current farm assets are those expected to be converted to cash or used up in the current year. Examples include cash, supplies, market livestock, feed and hay inventories. Current liabilities are those expected to be paid this year and include the principal due this year on longer term notes. Lower current ratios can be supported by farms with income coming in regularly, such as dairies, rather than once a year as with a specialized grain farm. If the current ratio is very low, a potential “fix” is to reschedule debt to reduce the amount of current farm liabilities. A portion of the debt is shifted from this year to future years, extending the length of indebtedness, but reducing the burden in the short term. Low Stress High Stress

Measuring Solvency Debt/asset ratio = Total farm liabilities Total farm assets Credit is like a buzzsaw, useful in the hands of a skilled craftsman, dangerous in the hands of others. May also see 30 and 60% used as benchmarks for stress levels. Having a high d/a ratio means a higher risk situation. A crop failure or other disaster can end the business. For financial analysis purposes, better to use cost basis for value of assets as those values are more stable over time than market values. How to improve the d/a ratio? Pay down debt. 50% is the threshold used to qualify for eligibility for an interest rate subsidy through the Oklahoma Ag Linked Deposit program. Low Stress High Stress

Measuring Profitability Net Farm Income = Gross farm revenue - all farm operating expenses incurred to create those revenues +/- gains/losses on sale of capital assets Accrual adjusted measure is best. That means accounting for income that is generated but not realized, for instance, heifers born and raised for replacements. It also means recognizing non-cash expenses, such as changes in inventories of hay and depreciation. Being profitable positively impacts all other measures. Net farm income for tax purposes is not sufficient in a given year to indicate profitability. (Ten year record should however give an indication.) How to improve profitability? Conduct a management audit. Look at enterprises to determine whether they are pulling their weight. Should you be producing hay or buying it? Growing wheat or renting pasture? Cost control is important. Negative net farm income means equity is being eroded. Using up wealth built up over time. Net farm income from operations (excluding gains/losses on assets sold) is even better as an indicator of profitability of the operation. Low Stress High Stress

Measuring Profitability Rate of Return on Farm Assets = (Net farm income from operations + farm interest expense - value of unpaid labor & management) (Average total farm assets) ROA is an index. Compare this to the cost of capital, e.g. a 10% interest rate. If you are paying 10%, but only earning 3% the borrowed money is not being used profitably. Family living expense is used as a proxy for the value of unpaid labor and management. Average farm assets = (total value at beginning of year + total value at end of year)/2 For financial analysis purposes, better to use cost basis for value of assets as those values are more stable over time than market values. ROA in ag is low compared to other industries. However, historically appreciation in the value of assets such as land has provided other compensation. This has not been as true in recent years however, particularly in rural areas in western OK. How to improve it? Improve profitability, lower interest expense, lower family living withdrawals. Low Stress High Stress

Measuring Profitability Rate of Return on Farm Equity = (Net farm income from operations - value of unpaid labor & management) (Average total farm equity) ROE is an alternative index, used to compare to rates of returns in alternative investments, such as CDs or stock market index funds. Probably want to earn as much on $ invested in farm as you could if it were in the bank. Equity = Assets - debt = owner’s claim to assets. For financial analysis purposes, better to use cost basis for value of assets as those values are more stable over time than market values. Do red lights mean a wreck is inevitable? Most have run a red light and lived to tell about it. However, wouldn’t recommend it as a practice if you want to live a long life! How to improve it? Improve profitability, lower interest expense, lower family living withdrawals. Low Stress High Stress

Measuring Efficiency and Repayment Capacity Interest Expense Ratio = Total farm interest expense Gross farm revenues 20% threshold means 1/5 of sales are used to pay interest. How to fix it? Pay down debt. Seek ways to reduce interest rate. Low Stress High Stress

Measuring Efficiency Asset Turnover Ratio = Gross farm revenues Average total farm assets How to improve it? Increase revenues relative to asset base by improving profitability, double-cropping (including using wheat pasture for livestock), rent rather than own assets. Will be different for different types of operations. Stockers on wheat operations using rented land will have high turnover ratios relative to cow/calf operators with a lot of owned land. Low Stress High Stress

Stress Test Exercise