1. Farm Financials: Starting with Your Schedule F and Building from There Paul Dietmann, Emerging Markets Specialist Badgerland Financial Paul.dietmann@badgerlandfinancial.com 608-370-6956 New Farmer U Lanesboro, MN October 21, 2016

2. Badgerland Financial – Rural lending (& other financial services) cooperative – Farm Credit System association – 350 employees, 17 offices – Serves 33 counties in Southern Wisconsin – 16,000 members – Largest ag lender in Wisconsin – Paid $13.5 million in cash dividends to farmers/members for 2015 business

3. What we’re going to cover this morning… How your Schedule F can be used for business management— not just tax management —purposes Cash flow and profitability; they’re two different things How to evaluate your farm’s cash flow An overview of the annual balance sheet Using the Schedule F and balance sheets to create an income statement & determine profitability

4. Our example farm: Happy Farmer CSA Happy Farmer has 150 members and also sells through farmers’ markets and some wholesale accounts. The Happy Farmer purchased its farm a few years ago and has a mortgage on it. There is a modest line of equipment and a few small outbuildings. There is no debt other than the mortgage. Happy Farmer’s owners feel like the farm is doing okay financially. They keep up on invoicing, pay most bills on time, and keep records that are good enough to get their taxes done. However, after paying all of the bills, there isn’t much left. They want to know if all their hard work is worthwhile.

6. Their Schedule F shows a profit of $44,312 but they definitely aren’t ending up with an extra $44,312 in their checking account at the end of the year. What’s the deal?

7. Let’s look more closely at the Schedule F Most of the entries are based on cash that came in or was paid out during the year A big exception is depreciation, a non-cash expense that can vary a lot from year to year It only pertains to the farm business; the farm family’s personal expenses aren’t included

8. Using the Schedule F for business management purposes Need to ensure that it’s an accurate picture – Of the year’s income – Of the year’s expenses

9. Schedule F farm income

10. Income questions Is this a typical year’s income? – Did you receive payment in 2014 for items sold in 2013? – Are you still waiting to be paid for stuff you produced and sold in 2014? – Are there other items you typically sell that don’t show up on Schedule F? Were there items you produced but didn’t sell? (vegetables consumed at home, donated to food pantries, bartered, added to inventory, provided to members, friends, family, etc.)

11. Only the farm’s portion of mortgage interest appears on Schedule F Schedule F farm expenses

12. Expense questions Are any expenses artificially inflated? – Charged to the farm but actually personal – Prepaid next year’s supplies during the current year – Two years’ of property taxes paid in one year – Big, out-of-the-ordinary repair bills Any expenses artificially low? – Using up supplies purchased the year before – Not fully accounting for labor cost – Were all expenses actually paid?

13. Filing a farm income tax return is a wonderful thing Forces us to keep good records Forces us to track cash farm income Forces us to track cash farm expenses Forces us to think about depreciation Usually done on a calendar-year basis, which makes it easy to do year-to-year comparison I love doing taxes!!

14. Need good records to get accurate Schedule F Keep your recordkeeping system simple Use a system you can easily maintain Set up categories in your “chart of accounts” that make sense to you in your operation Make sure your categories flow into Schedule F categories

15. Feed Hogs Corn Soybean meal Mineral mix Cattle Corn Hay Salt and mineral

16. Choosing a recordkeeping system Complexity of the farm operation Level of detail wanted or needed Employees and payroll? Farmer’s comfort level in handling recordkeeping Budget available for recordkeeping

17. What records should we keep? Farm income and expenses Sales and purchases of capital assets separate from normal income and expenses Accounts receivable and payable Farm loans – principal balances and interest accrued or paid Inventories of raised products and supplies on-hand Values of machinery, buildings, other improvements Documented on Schedule F Documented on a “balance sheet”

18. 18 Recordkeeping options Ledger book or handwritten records – Cheap and easy to use – Fine for small, less complex farms – Time consuming, won’t catch math errors – Generating data for analysis can be limited Computerized records (Excel or accounting software) – Usually more expensive to purchase & update – Customizable to your operation, easier for analysis – Many reports available at the push of a button – Can be used on your farm or through an accounting service

19. Farm accounting software options QuickBooks – Accounting Software for small businesses financial management and bookkeeping. – Customizable for agriculture – Can be easy to learn, instruction & support readily available – Available at office supply stores or at www.quickbooks.com CenterPoint (Red Wing) – Offers full set of financial reports for tax and business management – Ag-specific and adaptable to large and small operations – Training available – www.redwingsoftware.com

20. Farm accounting software options Easy Farm – Offers farm record-keeping, crop & field tracking and livestock management – Available through Technical College Farm Business instructors – www.easyfarm.com AgManager – Ag-specific accounting product – Full scope of financial reports: payroll, resale inventory and managerial accounting. – Can be fully customizable to adapt to your operation. – www.agrisolutions.com AAIMS – Ag-specific – Offers major financial statements and payroll – Available through UW Wisconsin Center for Dairy Profitability – cdp.wisc.edu/software.htm Low-cost or free cloud-based programs – FreshBooks, Wave, GnuCash

21. Recordkeeping options Accounting service – Trained in accounting and payroll, and stay up-to-date on current laws and regulations – Resource for questions and business management – Can be a “custom hire” service for records cleanup or accounting processing – Provides you with detailed, accurate accounting records you can use to analyze your business – Be sure your accountant understands agriculture 21

22. Beginning to analyze Happy Farmer’s cash flow

23. What is “cash flow?” The ability of the farm to generate enough cash to cover all expenses and all loan payments when due, pay for family living costs and any income taxes owed, and still have some cash left for reinvestment in the farm and to put something into savings.

24. Cash Flow and Profitability Related to each other, but very different – Can have strong cash flow and be unprofitable – Can be profitable with poor or negative cash flow Cash flow is absolutely critical! Profitability and cash flow are both important for the farm to be economically sustainable

25. Remember $44,312? That’s not cash flow. (It’s not really “profit” either, but we’ll set that aside for now.)

26. Happy Farmer’s cash flow the year they showed $44,312 Schedule F profit

27. Happy Farmer’s cash flow It’s positive for the year It wasn’t positive every month We don’t know if it is positive enough – Is there enough extra cash to replace stuff that rusts, rots, or wears out? – Is there enough to adequately save for a rainy day?

28. Now we need Happy Farmer’s balance sheet

29. What’s a balance sheet? A snapshot of the investment in the farm business (assets) and the financing methods used (a combination of liabilities and owner’s equity) at a point in time. A balance sheet measures the financial position of your farm.

30. What’s so great about a balance sheet?! Documents the value of your farm business assets at a point in time…preferably January 1 Summarizes all of your farm’s liabilities Shows progress you are making in the business even if cash flow seems tight Aligns with your Schedule F, which makes financial analysis easy

31. Three parts of a balance sheet Assets – Everything that is owned by or payable to the farm on the date the balance sheet is prepared Liabilities – All obligations owed by the farm on the balance sheet date Owner’s Equity or Net Worth – Total assets minus total liabilities

32. How farm balance sheets are different from those of other businesses Assets usually listed at market value rather than cost basis Categories for intermediate assets and liabilities Often difficult to separate farm assets from personal assets

33. Key information from balance sheet Liquidity – Ability of the farm to meet its current (short term) liabilities with current assets Solvency - Ability of the farm to pay off all of its debts if it were to be sold tomorrow 8 more buckets of liquid assets!

35. Liquidity (current assets vs current liabilities) Current assets: Cash and anything that will either be converted to cash or used up within a year – Crop and feed inventories, market livestock inventories – Growing crops – Accounts receivable – Prepaid expenses and supplies

36. Current liabilities: Anything that is due now or will come due within a year – Accounts payable – Principal due within a year on term loans – Accrued interest on term loans – All principal and accrued interest on operating loans Liquidity (current assets vs current liabilities)

37. Liquidity ratios Current ratio – Current assets divided by current liabilities GOAL: The current ratio needs to be at least 1.0, preferably 2.0 or more Working capital – All current assets minus all current liabilities GOAL: Working capital at least 15% of annual gross farm income

38. Working capital is a key measure of risk Current Assets – Current Liabilities = Net Working Capital Net working capital should be at least 15% of the annual gross revenue of the farm Strong working capital position allows the farm to: a) withstand an unexpected setback b) take advantage of an unexpected opportunity

39. Happy Farmer’s working capital 1/1/14 Happy Farmer’s net working capital is $5,913 Since annual gross revenue of the farm was $110,000, the net working capital should be $16,500 (15% of annual gross revenue). We are short by $10,587. We should plan to eliminate the deficit over four years from cash flow $10,587 ÷ 4 years = $2,646 that needs to come from cash flow each year

40. Working capital consists mainly of crop & feed inventories and receivables, not much cash (10-15% of a farm’s current assets should be held in cash) Using up too much cash on capital purchases instead of building working capital reserves Operating losses carried forward year-to-year on credit cards, lines of credit, open accounts Poorly structured debt such as carrying capital purchases on an operating loan Large, unplanned expenses Common liquidity problems

41. Solvency ratios Debt to Asset: Total debt/total assets – How much of the farm’s assets are owed to creditors? – Should be less than 50% Equity to Asset: Equity/total assets – How much of the farm’s assets are owned by the farmer? – Should be more than 50% Debt to Equity: Total debt/equity – How many dollars of debt does the farm have for each dollar of the farmer’s equity? – Should be less than 1.50. Less than.45 is a good long-term goal.

42. Taking on term debt to cover years of negative cash flow Too little cash flow after paying bills and making loan payments to maintain buildings & equipment Erosion in market values of assets Big capital investments that don’t add much to the farm’s market value Assets depreciating faster than the loan balances are being paid off Common solvency problems

43. Your turn to do a balance sheet!

44. Balance sheet exercise Place all of the numbers in the right slots on the balance sheet Calculate the current ratio Calculate working capital Calculate the debt-to-asset ratio Would you say this is a strong balance sheet?

46. Balance sheet exercise Place all of the numbers in the right slots on the balance sheet Calculate the current ratio2.85 Calculate working capital$37,669 Calculate the debt-to-asset ratio38% Would you say this is a strong balance sheet? Yes.

47. Now that we have a balance sheet, we can finish analyzing Happy Farmer’s cash flow

48. Annual statement of cash flows A year-end analysis of all cash that flowed into the operation (including loan proceeds) and all cash that flowed out (including family living expenses, taxes, principal and interest payments). Where did the farm’s cash come from? Was there enough cash income to cover operating expenses, income taxes, family living costs, and loan payments? Was there enough cash left to replace stuff that’s rusting, rotting, or wearing out? Was there cash available to build up working capital?

49. To analyze cash flow, we need to break it out Beginning cash balance Cash flow from operations Cash flow from investing activities Cash flow from financing activities Net change in cash Ending cash balance

50. Annual statement of cash flows Beginning cash balance $10,000 Cash flow from operations Vegetable sales $110,000 Farm operating expenses($ 52,850) Net cash from operations $ 57,150 Cash flow from investing Capital purchases($ 0) Capital sales $ 0 Net cash from investing $ 0 Cash flow from financing Proceeds from new loans $ 0 Loan payments($20,916) Off-farm wages $ 0 Family living draw($30,000) Net cash from financing($50,916) Net change in cash $ 6,234 Ending cash balance $16,234

51. Key cash flow ratio Replacement Margin Coverage Ratio (RMCR) – All cash available for debt repayment divided by total demands on available cash*. GOAL: Higher than 115% *net cash farm income minus family living expenses and income taxes, plus interest on capital debt scheduled P & I payments plus cash needed for both Capital Asset Replacement and working capital

52. Machinery $25,000 x 15% = 3,750 Bldgs $40,000 x 5% = 2,000 $5,750 Working capital deficiency $2,646 Replacement Margin Coverage Ratio RMCR should be higher than 115% Breakdown for Line 13: Principal and Interest payments $250,000 mortgage, 5.5% interest, 20-yr amortization$20,916

53. Machinery $25,000 x 15% = 3,750 Bldgs $40,000 x 5% = 2,000 $5,750 Working capital deficiency $2,646 Replacement Margin Coverage Ratio RMCR should be higher than 115% Breakdown for Line 13: Principal and Interest payments $250,000 mortgage, 5.5% interest, 20-yr amortization$20,916 What if we add $12,000 non-farm income?

54. With the Schedule F and the year’s beginning and ending balance sheets, we can analyze profitability

55. 55 Items with a star need to be “accrual adjusted” on the Income Statement

56. 56 Items with a star need to be “accrual adjusted” on the Income Statement

57. Profitability is calculated with an income statement One year’s income and expenses, and how much profit was generated by the farm. It’s not a cash flow statement…it includes non-cash items. (The Income Statement is also known as a “Profit and Loss” statement)

58. Profitability - The ability of the farm to generate an adequate return on investment for your money, your time, and your labor

59. Why do we need an income statement? Gives us a way to account for everything of value generated by the farm during the year, not just the cash income that shows up on Schedule F. Gives us a way to account for all expenses incurred, not just those that were paid in cash. Tells us if the farm is generating an adequate return for the farmer’s devotion of time, labor, and money…Is the farm profitable?

60. How do we measure profitability? Rate of return on farm assets – The “interest rate” being earned on all of the investments in the farm (yours and lenders’). GOAL: Higher than interest on borrowed money Rate of return on farm equity – The “interest rate” being earned on YOUR portion of the investment in the farm. GOAL: Higher than ROROA

61. The Income Statement Income – Includes cash sales of farm products, government payments, custom work income. Also includes changes in inventories of feed, crops, and livestock, and changes in prepaid expenses, accounts receivable, payables, and accrued interest. Expenses – Includes all cash operating expenses including interest (but not principal) payments. Also includes depreciation.

62. Income GROSS FARM INCOME $110,000 (Sch. F, line 9) Expenses Schedule F cash operating expenses $52,850 (Sch. F expenses, excluding depreciation & interest) Interest on farm loans $7,838 (Sch. F line 21) $60,688 TOTAL CASH FARM EXPENSE $60,688 Net CASH Farm Income $49,312 Changes in accrual categories+/- (Jan. 1 2014 & 2015 balance sheets) Total accrual adjustments +/- $ ---- -Economic depreciation $5,750 NET FARM INCOME $43,562 Economic depreciation (balance sheet) Machinery $25,000 x 15% = $3,750 Buildings $40,000 x 5% = $2,000 Income Statement

63. Rate of Return on Assets Net Farm Income$ 43,562 + Farm interest$ 7,838 - Value of farmer’s labor$ 30,000 Return on farm assets$ 21,400 $21,400/$238,117 (avg farm assets) = 8.98% 63 ROROA should be higher than the interest rate on farm loans

64. Rate of Return on Equity Net Farm Income$ 43,562 - Value of farmer’s labor$ 30,000 Return on farm equity$ 13,562 $13,562/$97,660 (avg farm net worth) =13.89% 64 Rate of Return on Equity should be higher than ROROA

65. What about these “accrual adjustments?” Example: If the Happy Farmer increased their credit card balance from zero at the beginning of the year to $6,000 by the end of the year (an increase in accounts payable), we would need to adjust net farm income down by $6,000.

66. Income GROSS FARM INCOME $110,000 (Sch. F, line 9) Expenses Schedule F cash operating expenses $52,850 (Sch. F expenses minus depreciation & interest) Interest on farm loans $7,838 (Sch. F line 21) $60,688 TOTAL CASH FARM EXPENSE $60,688 Net CASH Farm Income $49,312 Changes in accrual categories+/- Accounts payable +$6,000 (Jan. 1 2014 & 2015 balance sheets) Total accrual adjustments -$6,000 -Economic depreciation $5,750 NET FARM INCOME $37,562 Economic depreciation (balance sheet) Machinery $25,000 x 15% = $3,750 Buildings $40,000 x 5% = $2,000 Income Statement

67. Rate of Return on Assets after accrual adjustment Net Farm Income$ 37,562 + Farm interest$ 7,838 - Value of farmer’s labor$ 30,000 Return on farm assets$ 15,400 $15,400/$238,117 (avg farm assets) = 6.4% 67 ROROA should be higher than the interest rate on farm loans

68. A few suggestions Quality of life should be #1 business goal Need to have positive cash flow to keep doing what you love to do Doesn’t make sense to borrow money at 6% to achieve a 3% Rate of Return on Assets Always do a January 1 balance sheet Don’t draw any big conclusions from one year’s financials 68

69. Investment Analysis

70. Resources Three resources provided to us for free: sunshine; wind; and precipitation Three resources we have available to invest: our labor; our time; and our wealth Everything else can be borrowed, bought, or rented Approximately 40 productive years

71. The big question: How do we make the wisest use of all of the resources at our disposal?

72. If we can develop cash flow projections for our investment options, we can use Net Present Value to analyze each option, and Internal Rate of Return to compare one to another.

73. Time value of money The sooner you receive money, the better – Money you get today can be invested or used to stop interest from accruing – Inflation causes money to lose buying power over time Benefit of investments are in the future – The longer you have to wait for money to come in, the less it is worth to you today – We need to adjust values for the cost of waiting – The longer you wait, the greater the risk that you won’t get paid back

74. 74 Source: investopedia.com, Understanding the Time Value of Money In Option A, we are “compounding” In Option B, we are “discounting”

75. Net Present Value (NPV) Tells us what a future cash payment is worth in today’s dollars Converts a stream of future cash flows into a single current value Can tell us if an opportunity is a good investment It won’t tell us if it’s our best investment of dollars

76. Scenario: Sunseed Farm’s D-10T potato digger Sunseed Farm bought a new potato digger for $10,709. Estimating that they made a 20% down payment and financed the balance at 5% for 7 years, the payment on the digger is approximately $1500/year. Net operating cash flow of growing potatoes increased by $487/acre/year with the digger (some operating expenses but much lower labor cost). Without the digger, they could grow one acre of potatoes digging them by hand. With the digger, they grew two acres in 2015, will grow 4.5 acres in 2016, and at least 5 acres in future years. They plan to use the digger for at least ten seasons. It should be worth at least $3,000 at the end of the tenth season.

77. It is tempting to do this really simple calculation: One year x $487 x 2 acres = $974 One year x $487 x 4.5 acres = $2,192 Eight years x $487 x 5 acres = $19,480 Salvage value $3,000 $25,646 Minus the initial down payment($2,142) Minus 7 years loan payments($10,500) =Net cash flow for 10 years $13,004 This suggests you’d get a 607% return on your initial investment ($13,004/$2,142 = 607%), which is NOT TRUE. This calculation doesn’t consider the time value of money. To consider the time value of money, we need to apply a discount rate. 77

78. How do we establish a “discount rate?” 78 We could use the interest rate we would have to pay to get a loan for the capital purchase We could use the prime lending rate and add to it the rate of inflation We could set a personal “hurdle rate”…the least return you’re willing to accept Whichever method we use, we need to adjust for the riskiness of the investment. The more risky it is, the greater the discount factor.

79. YearAnnual Net Cash Flow Discount Factor @ 5% Present Value of Annual Net Cash Flow 1($526).9523($501) 2$692.9070$628 3$935.8638$808 4$935.8227$769 5$935.7835$733 6$935.7462$698 7$935.7107$664 8$2435.6768$1648 9$2435.6446$1570 10$2435 + $3,000.6139$3337 Net Present Value of the cash flows$10,354 Since the initial cash outlay was $2,142, it makes sense to make the investment. But, if the return isn’t 607%, how much is it???

80. How good is the investment in the potato digger? (You can download this spreadsheet from: http://www.badgerlandfinancial.com/en/Pages/Resources.aspx)

81. What about making a bigger investment…like buying a farm? 81

82. Another scenario: You have been renting a farm for $12,000/year, saving up for a down payment, and hoping for an opportunity to buy it. The day has come; you can buy the farm for $250,000. You will need to put down $75,000 and finance $175,000 on a 20-year note at 5% interest = $14,042/year payment You’ve developed a cash flow projection. With loan payments, property taxes, and annual building repairs & improvements, your cash outlay will be $10,000 more each year owning the farm compared to renting it. However, you will be building equity and expect the farm’s market value to increase by 4% each year. You really want to buy this farm BUT is it a good investment? 82

83. Factors to consider Cash outlay is $75,000 Net annual cash flow is estimated to be ($10,000) compared to continuing to rent the farm Farm should be worth approximately $304,000 in five years Mortgage balance in five years will be approximately $145,000 Owner’s equity in five years will be $159,000 minus “contingent liabilities,” an estimate of sales costs that would have to be paid if the farm was sold – $304,000 x 8% = $24,000 – $159,000 - $24,000 = $135,000 estimated owner’s equity 83

84. Does it make financial sense to buy the farm? We can use our Net Present Value and Internal Rate of Return tools to analyze the investment 84

85. NPV of cash flows for the farm YearAnnual Net Cash Flow Discount Factor @ 5% Present Value of Annual Net Cash Flow 1($10,000).9524($9524) 2($10,000).9070($9070) 3($10,000).8638($8638) 4($10,000).8227($8227) 5($10,000) + $135,000.7835$97,938 Net Present Value of the cash flows$62,479 Since the initial cash outlay was $75,000, this is NOT a good investment. 85

86. How “not good” is the investment? 86

87. Some cautions This is only the beginning, not the whole story There can be good reasons to make a capital investment even if the NPV/IRR calculation doesn’t support it Don’t substitute enterprise budgeting or investment analysis for whole farm financial planning Month-by-month cash flow projections are extremely important if you are relying on income from your farm to support family living costs People become farmers for many different reasons; high profitability is not usually #1. And that’s okay! 87