Oklahoma AgrAbility Newsletter
Fall 2006 • Volume 5 • Issue 4
Reducing Risk Using Financial Statements
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NOTE: Mention or display of a trademark, proprietary product or firm in text or figures does not constitute an endorsement by the U.S. Department of Agriculture, Oklahoma State University, Langston University or the National AgrAbility Project and does not imply approval to the exclusion of other suitable products or firms.
In This Issue
Reducing Risk Using Financial Statements
Financial Statements as Management Tools
Analyzing Performance with Financial Tools
Cattle Herd Management During Drought
Peer Advocate Makes Hay while the Sun Shines
Reducing Risk Using Financial Statements
Production agriculture has many inherent risks, such as weather and commodity prices. Financial risks related to farming and/or ranching can be reduced by making educated decisions based on accurate financial statements. Timely and accurate financial information is crucial for managers to make good decisions regarding their operations. Studies have shown the quantity and quality of information is directly related to the success or failure of a business.
The first step in developing financial statements is knowing where to find necessary information. Possible sources include income tax records, bank statements, record books and monthly bills.
Farmers and ranchers in Oklahoma needing assistance developing or analyzing financial statements have several options. First, as the financial specialist for the Oklahoma AgrAbility Project, I am available to work with existing and new AgrAbility clients. Other organizations providing assistance are OSU Cooperative Extension offices, the Noble Foundation, the Kerr Center for Sustainable Agriculture, plus several local vocational technology centers.
Clark Williams, AgrAbility Farm Financial Specialist
Financial Statements as Management Tools
Developing accurate financial statements assists farm and ranch managers in meeting documentation requirements for loan requests and provides management tools for examining the financial health of the operation.
The balance sheet and income statement are the primary financial statements. From the balance sheet, the financial position of an operation may be determined by examining relationships between assets, liabilities and owner's equity. The income statement indicates performance by showing how income was generated, how expenses were incurred and how debt payments were met during a year.
The Balance Sheet
Assets are owned items that provide a beneficial economic resource to the farm operator. They normally are classified as current or non-current.
Current assets include cash, items that can be converted into cash with little difficulty and items that will turn into cash within the normal operating cycle of business. Current assets are listed according to their liquidity, with the most liquid appearing first. Common categories of current assets in the balance sheet are cash and checking, which are the most liquid; savings accounts; investments and securities; accounts receivable; feed and hay; and livestock to be sold.
Non-current assets are owned items with economic lives greater than one year. All depreciable assets are non-current. Common non-current assets include breeding livestock, machinery and equipment, buildings and improvements, and real estate.
Liabilities represent everything owed in the form of cash, products or services, and also are classified as current or non-current.
Current liabilities will become due within one year and will be paid with a current asset or the creation of another current liability. Current liabilities include accounts and notes payable, and current portions of non-real estate and real estate loans.
Non-current liabilities have a maturity more than one year. Only the principal balances of non-current loans need to be included, as accrued interest is a current liability. Non-current liabilities are principal balances on non-real estate and real estate loans.
The owner's equity is calculated by subtracting total liabilities from total assets. Equity represents the portion of the farm operator's ownership in the business. If assets increase more than liabilities, equity will increase. In a balance sheet, assets must equal liabilities plus owner's equity.
The Income Statement
The income statement is a summary of income and expenses for the fiscal year. It includes cash and non-cash values and is used to measure business profit.
The income statement is divided into revenues and expenses. Farm revenues are derived from the normal operations of business, including the sale of crops, feed, livestock, livestock products and government payments. Farm expenses also are derived from normal operations of business. Cash operating expenses are divided into categories, and the most common categories correspond to the list of expenses on Schedule F of the IRS tax form.
Net farm income is what remains after subtracting total expenses from total revenue. It is the amount of income generated by production during the year.
A pro forma income statement, or a projection of income and expenses for the next fiscal year, can be a valuable planning tool for farming or ranching operations. It is also a requirement for loan applications and business plans.
Common Financial Terms
• Assets: owned items that are economic resources
• Liabilities: cash, product or service items owed
• Equity: net worth; portion of ownership in a business
• Net farm income: profit
• Liquidity: ease of conversion of assets to cash
• Balance sheet: provides information about assets, liabilities and equity
• Income statement: summary of income and expenses for the fiscal year
Analyzing Performance with Financial Tools
As agriculture moved from subsistence production to modern businesses using land, labor and capital with the expectation of making a profit, the need to measure financial position and performance increased.
Financial measures enable farm operators to compare past and present performance, present and budgeted performance, and multi-year performance trends using the measures most beneficial to specific situations.
Ratio Analysis
Financial ratios are accepted methods of measuring financial position and performance by comparing two elements of financial data expressed as a percent or comparison to a percent.
The four categories of financial measures are liquidity, solvency, profitability and efficiency. All data needed for the ratios can be found on the balance sheet or income statement.
Liquidity
Liquidity measures the ability of a business to meet financial obligations as they come due. It is calculated by dividing total current assets by total current liabilities.
The higher the ratio, the greater the liquidity. A ratio of 1:1 is marginal. A ratio of 2:1 is considered good.
Solvency
Solvency measures the amount of debt relative to the amount of the owner's equity in the business and provides an indication of the firm's ability to repay financial obligations if all assets were sold. It is very important to lenders.
Solvency, or the debt to equity ratio, is calculated by dividing total liabilities by owner's equity. It reflects the extent to which farm debt is being combined with farm equity. The ratio should be less than 1:1, with lower ratios representing increased solvency.
Profitability
Profitability, measures the extent to which a business generates profit from the use of land, labor, capital and management. Also called return on assets, the ratio is calculated by dividing net income by total assets.
This ratio measures the rate of return on farm assets and is often used as an overall index of profitability. It is normally expressed as a percent. The higher the value, the more profitable the farming operation.
Efficiency
Efficiency, or the turnover ratio, measures the intensity with which a business uses its assets to generate gross revenues. It is calculated by dividing total annual revenue by total assets.
This ratio is a measure of how efficiently farm assets are being used to generate revenue. The higher the value, the more efficiently the assets are being used.
Analyzing Trends
Trend analysis is another simple way to measure financial performance. A trend indicates a direction or movement over time. To determine a trend, you make a comparison of the same measure over a period of time. In terms of financial analysis, this time period is two or more years.
Trends may be used to analyze ratios and data from past, present and future financial statements. Data that are commonly analyzed using trend analysis include total assets, total liabilities, owner's equity, total revenue, total expenses and net income.
Financial Formulas
Liquidity
Current ratio = Current assets / Current liabilities
Solvency
Debt/equity ratio = Total liabilities / Owner's equity
Profitability
Return on assets = Net income / Total assets
Efficiency
Turnover ratio = Total revenue / Total Assets
For More Information
Clark Williams
Farm Financial Specialist
Oklahoma AgrAbility Project
(405) 466-6101
Oklahoma Cooperative Extension Service
Samuel Roberts Noble Foundation
(580) 223-5810
Kerr Center for Sustainable Agriculture
(918) 647-9123
Cattle Herd Management during Drought
Keeping in mind a few simple herd management strategies may help farmers and ranchers stay in business and maintain their finances under the drought conditions.
Providing mineral and protein supplements where pasture is plentiful but low in quality will help cattle maintain forage intake and utilization and avoid weight loss.
Where pasture is lacking in quality and amount, limited feeding of range cubes temporarily may alleviate forage shortages. When pasture becomes extremely short, purchase of hay or a replacement feed for pasture must be considered, as well as selling of stock.
Some producers will need to reduce herd size due to the high cost and potential unavailability of quality hay and feed. From an economic standpoint, it is better in the long run to destock than accumulate additional debt while buying hay and feed. The more quickly stocking adjustments are made, the less severe herd reductions will need to be. See the sidebar for a logical approach to culling.
Producers commonly make three mistakes when facing a drought. The first is to do nothing in hopes that conditions will improve. Second, calves often are weaned early to avoid selling cows. However, cows eat the majority of forage. Third, young cows are kept at the expense of more productive (4- to 7-year-old) cows.
Surviving prolonged periods of drought can be expensive and frustrating. Ensuring your operation can continue in the future may require strategic herd management to efficiently use available resources.
Logical Herd Culling
Research from Texas A&M University demonstrated an effective system for culling cows during a drought. Three groups should initially be considered for culling.
1) Spring- or summer-calving cows without a calf. Also include fall- and winter-calving cows that did not raise a calf.
2) Replacement heifers not raising a calf.
3) First-calf heifers because they typically wean smaller calves and rebreed at a lower percentage than mature cows.
Culling these three groups of animals will not significantly affect this year's calf crop but will reduce feed and forage needs. More importantly, the remaining forage will be available for cows contributing to the income of the operation. If additional culling is required, it will start impacting this year's calf crop. This is difficult for most producers to accomplish but may be necessary.
Additional culling should continue to follow logical steps.
4) Historically poor or questionable producers.
5) Broken-mouth cows, as they are at a disadvantage during a drought.
6) Genetically inferior cows.
7) Open cows that have calves, as pairs.
If further culling is required, cull the oldest cows, regardless of production status.
Peer Advocate Makes Hay while the Sun Shines
Take advantage of your opportunities – such as obtaining help from the Oklahoma AgrAbility Project – was the first advice Keith Best offered people with disabilities who want to continue working in agriculture.
“They need to get a hold of (AgrAbility),” Best said. “I didn’t have any guidance. I had to do things by trial and error.”
Best had bilateral upper and lower extremity amputations due to injuries and frostbite he sustained in a plane crash in 1971. After four months in the hospital and intensive physical therapy, Best returned home.
With deep roots in agriculture, Best maintained a cow/calf operation until 1998. When his cows became “too tame” to handle properly, Best and his wife began raising only hay – weather permitting, of course.
Best was trained in April to be a peer advocate in the Oklahoma AgrAbilty Support Network. Through the network, peers with experience adapting to disabilities will be connected with farmers or ranchers with newly acquired disabilities to support their adaptation to disability issues.
“If someone has a disability and wants to continue farming, they should talk to us, the counselors, and find out how we did it,” Best said.
In other words, make hay while the sun shines.
This newsletter was supported in part by USDA-CSREES grant award number 2006-41590-03434.