Using financial records……

Using financial records…… To answer all sorts of questions you or others may have… Craig Chase, Field Specialist Farm & Ag Business Management

Plan for today • Quickly review goal setting and planning • Six reasons to keep financial records • We are going to cover these six 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…

Goal Setting and Planning • How much production do I need to have? • How big do I need to be (number of acres, head of livestock, etc.)?

Issue of Scale • Assume you want to grow vegetables. • You also want to make $30,000 per year net income. • Question: How many acres do you need to have in production?

Issue of Scale • Assume your goal is to have a net income ratio of 30 percent. • Gross revenue would need to be $100,000 ($30,000 / 30%). • Number of acres assuming $15,000 gross revenue per acre would need to be 6.7 ($100,000 / $15,000). • (e.g. $15,000 = 50 shares/acre @ $300 / share)

Additional Planning Needs • What will my labor, equipment, and land needs be as I expand? • How do I decide where to invest my money first? • What do I do when things don’t go as planned (pp. 31-42)?

Reason #1 • How is my farm doing financially? • How much of my farm do I own? • How much money am I actually making farming?

Financial Condition and Profitability • Financial condition can be shown by the balance sheet. • Profitability can be illustrated by the income statement. • Both of these statements need to be for your entire farming operation.

Balance Sheet, as of 12/31/2011 Assets 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 12/31/2011 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 I make any money? • Net income of $17,000 • Net income plus depreciation of $53,000 • How much of my farm do I 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 (pp. 89-100). • Income statement presents what was made over one time period (pp. 101-109). • 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 12/31/2011 Assets 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 12/31/2011 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 my farm compare to other farms? • What are the strengths and weaknesses of my farm? • What could I 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? • 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 • 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 • 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 I borrow? • What will a lender think of my idea? • What information should I pull together to show my 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.

Reason #4 • Can I do a better job of production (can I be more efficient)? • Which crops (livestock) should I grow (raise)? • How do I price my product(s)? • Which market(s) makes the most sense?

Enterprise Budget • An enterprise budget is an estimate of costs and returns to produce a product (pp. 160-172). • For producers who grow a large number of different products. • Develop budgets for those products that contribute the most to business goals.

Enterprise Budget • Or start with an enterprise budget for each major part of your business. • Example, CSA with poultry/livestock. Complete a CSA and livestock budget. • CSA with multiple seasons and use of high tunnels/greenhouses. Complete an enterprise budget for each season (spring, summer, fall) or production system (open ground, high tunnel, greenhouse). • The process is the same for all scale of farming operations.

Simplified Enterprise Budget Salad Greens (4x100 ft bed) Revenue: 30 lbs @ $5.00/lb $150.00 Crop inputs: (Seed, fertilizer, etc.) 7.00 Labor 28.00 Supplies 1.00 Ownership (machinery, land, irrigation) 11.00 Total cost $ 47.00 Return over total cost $103.00

Simplified Enterprise Budget Green Beans (4x100 ft bed) Revenue: 120 lbs @ $3.00/lb $360.00 Crop inputs: (Seed, fertilizer, etc.) 23.00 Labor 182.00 Supplies 4.00 Ownership (machinery, land, irrigation) 11.00 Total cost $ 220.00 Return over total cost $140.00

Enterprise Budget Analysis • Enterprise budgets can be used to: • Look at how changes in production practices could improve profits. • Review your product mix. • Price your product.

Changing Production Practices Use the budgets to calculate break-even prices and yields. For example, cost per lb. of beans sold was $1.83 ($220/120 lbs). Compare this number to other producers or published budgets to determine where costs are different and why. NOTE: add marketing costs to your cost of production.

Changing Production Practices A second reason – track key costs. Green bean example, $182 (or 83%) of the total production cost is labor. Most of the labor is weeding and harvesting. Question - can labor be lowered without reducing yields (i.e., can labor be more efficient)? Crop inputs is a small percentage (10%) of total production costs, a 10% reduction in costs won’t affect total production costs significantly. Don’t spend time on small items…

Product Mix Enterprise budgets allow for a comparison of profitability and labor usage among the various crops grown. For example, green bean returns over total costs was $140. Labor usage was 18.25 hrs. Returns over total cost per hour was $7.69.

Product Mix

Comparing Budgets A quick comparison of the crops in the previous slide indicates annual returns over total costs ranged from $35.47 to $547.21. Labor usage ranged from 1.55 to 18.25 hours. Returns over total costs per hour ranged from $6.13 - $48.86.

Product Mix Summary Labor in most cases is your limited resource - limited number of hours for any farming operation. Analyze not only returns over total costs, but also returns over total costs per hour. Some products with lower returns over total costs may have higher returns over total costs per hour because of low labor requirements.

Pricing • Number #1 question…what price should I sell my products at (pp. 191-197)? • For an individual product, what does it cost me to produce AND market that product? • If tomatoes cost me $1.90 per lb. to produce and market, what should my price be?

Pricing (side note) • NOTE that we are not going over how to determine market costs today. • Marketing costs are extremely important, however, as they can be 2-5 times the cost of production. • Marketing costs are covered in the book on pp. 180-190.

Pricing • What are your consumers willing to pay and what is your competition allowing? • How much above your breakeven cost are these prices? • What is your net farm income ratio goal (10yr Iowa average for all kinds of farms was 20-25%)?

Pricing • So if you want to net 20% of your gross income and your break-even cost is $1.90 per lb., your sales price would be $2.38 per lb (2.38-1.90=0.48; 20% of $2.38). • Will your consumers and competition allow this price (maybe higher)? The goal is for the farm, not one product.

Pricing • Same process regardless of what you are producing… • Example – CSA share cost you $240 per share to produce and market, price it at $300. • Chickens cost you $2 per lb to produce and market, price at $2.50 per lb.

Exercises 4 and 5 • Take 15 minutes answering exercises 4 and 5 related to product mix and pricing using enterprise records.

Exercise 4 – Product Mix • What were your suggestions, if any?

Exercise 5 - Pricing • What is her per share cost for production and marketing? • Ans. $345 (($25,000+ $5,000 + $4,500) / 100) • What does she need to charge to achieve her net income goal? • Ans. $431.25 ($345 / .80) if all income is to come from shares, if 10% of total gross income comes from other sources, then this number can be reduced by 10%, or approximately $388 per share.

Using financial records……