Farm Management

1. Farm Management Chapter 6 The Income Statement and Its Analysis

2. What is an Income Statement? An income statement is a summary of revenues and expenses as recorded over a period of time.

3. Figure 6-1 Relation between balance sheet and income statement

4. Identifying Revenue and Expenses • Revenue: revenue should be recognized as soon as a commodity is ready for sale, whether or not it is actually sold • Gain or loss on sale of capital assets: difference between sale price and book value • Expenses: all expenses incurred in producing the revenue for an accounting period should be included

5. Net Income Statement, defined • Includes Revenues and Expenses • Revenues – Expenses = NET FARM INCOME (NFI) • Net Farm Income = Profit • Also known as a Profit & Loss Statement

6. Inventory Changes • Crops and Feed on Hand • Market Livestock • Accounts Receivable • Prepaid Expenses • Accounts Payable • Does this sound familiar?? CURRENT ASSETS on the BALANCE SHEET

7. Ending Inventory - Beginning Inventory = Inventory Change Inventory Changes • Current Assets have a life of < 1 yr • Balancing inventories accounts for the changes in these assets *Accounts Payable: Beg Inv – End Inv = Inv Change

8. Depreciation and Capital Adjustments • Breeding Livestock • Machinery & Equipment • Buildings and Improvements • Other Assets • Does this sound familiar?? INT and LT ASSETS on the BALANCE SHEET

9. Ending Inventory + Capital Sales • - Beginning Inventory • - Capital Purchases • = Depreciation / Capital Adjustments Depreciation and Capital Adjustments • Intermediate and Long Term Assets last > 1 yr • Depreciation calculates amount of asset “used up” during the last year

10. Depreciation • How much of the asset is “used up” during the year? • Lots of methods to calculate: • Straight line • Asset Value (cost basis)  Years of Life • Declining balance, Double-declining balance, Sum-of-the-Years Digits, Modified Accelerated Cost Recovery System(MACRS) • Tax implications of all methods

11. Use the information provided to make accrual adjustments.

12. Figure 6-2 Adjustments to get accrual-adjusted net farm income from a cash-basis income statement

13. Capital Adjustments • Made using cost basis of intermediate and long term assets • Using market basis of assets includes “valuation equity” • Valuation equity is change in asset values based on how the market value has increased or decreased

14. Capital Adjustments • Valuation Equity makes it hard to answer the following questions: Has inflation of your assets made you look like a good manager? Have you been doing a good job of managing the value of your assets? OR

15. Cost vs. Market Basis of Assets • Valuation equity a very good reason for making sure your balance sheets have BOTH columns • Cost basis of assets generate good numbers for you to compare your farm with itself over several years • Market basis of assets generates good numbers to compare your farm with “peers” for a single year

16. ANALYSIS

17. Farm Financial Standards Council • Academics, bankers, CPAs, economists, farmers • Designated 16 measures to assess farm financial health within following categories: • Liquidity • Solvency • Profitability • Repayment Capacity • Efficiency

18. Farm Financial Standards Council Measures

19. PROFITABILITY

20. Net Cash Farm Income Total Cash Farm Income – Total Cash Farm Expense • Similar to 1040F “Profit” • Missing only tax depreciation • Often very different from Net Farm Income

21. Net Farm Income(NFI) Total Cash Farm Income – Total Cash Farm Expense +/- Inventory Changes +/-Depreciation and Capital Adjustments • Return to farmer for unpaid operator labor, management, and equity • What happens to NFI? • Principal payments • Owner withdrawals • Capital purchases

22. Net Farm Income per Unit(NFI/Unit) ( Total Cash Farm Income – Total Cash Farm Expense +/- Inventory Changes +/-Depreciation and Capital Adjustments)  Average Number of Units • Units are some measure of farm inputs or outputs • Acres, cows, cwt milk, bushels? • Makes NFI somewhat comparable across farm sizes

23. Net Farm Income per Unit(NFI/Unit) ( Total Cash Farm Income – Total Cash Farm Expense +/- Inventory Changes +/-Depreciation and Capital Adjustments)  Average Number of Units • Units are some measure of farm inputs or outputs • Acres, cows, cwt milk, bushels? • Makes NFI somewhat comparable across farm sizes

24. Rate of Return on Farm Assets (ROA) • Measures the before-tax rate earned by the $ of capital invested in the business ( Net Farm Income + Interest – Value of Operator Labor & Mgmt)  Average Total Farm Assets

25. Rate of Return on Farm Equity (ROE) ( Net Farm Income – Value of Operator Labor & Mgmt)  Average Total Farm Equity • Determines the before tax rate earned by the owner’s equity in the business • If this value is higher than ROA, farm is efficiently utilizing borrowed capital

26. EFFICIENCY

27. Asset Turnover(ATO) • Indicator of asset efficiency • Dollars generated per dollar of assets Total Cash Farm Income  Average Total Farm Assets

28. Net Farm Income Percent(NFI%) Net Farm Income  Total Cash Farm Income • Indicator of operating efficiency • Indicates dollars kept for every dollar of revenue generated

29. Trend Analysis • Compares Balance Sheet Info across years • Cost Basis • Market Basis • Some Cash Flow Info • Nice place to look at values over time

30. Analysis of Net Farm Income • Rate of return on assets • Rate of return on equity • Operating profit margin ratio • Return to labor and management • Return to labor • Return to management

31. Adjusted Net Farm Income

32. Opportunity Costs of Labor and Management The opportunity cost of unpaid labor is the estimated amount that any unpaid farm labor could have earned elsewhere. The opportunity cost of management is the estimated amount that the operator could have earned for that management time had it been used in paid work.

33. Rate of Return on Assets(ROA) Rate of return return to assets ($) average farm asset =  100% on assets (%) value

34. ROA for I.M. Farmer $ 51,300 =  100% ROA $725,750 = 7.07%

35. Return on Equity

36. Rate of Return on Equity (ROE) Rate of return return on equity ($) average equity ($) =  100% on equity (%)

37. ROE for I.M. Farmer $ 21,800 =  100% ROA $358,565 = 6.08%

38. Comparing ROA and ROE If ROA > i then ROE > ROA If ROA < i then ROE < ROA Wherei is the interest rate on borrowed capital. Thus, if ROA > ROE borrowed capital is earning, on average, less than the interest rate. If ROA < ROE, borrowed capital is earning, on average, more than the interest rate.

39. Operating Profit

40. Operating Profit Margin Ratio operating profit Operating profit margin ratio  100% = total revenue

41. Operating Profit Margin Ratio for I.M. Farmer $ 51,300 Operating profit margin ratio  100% = $200,400 = 25.6%

42. Opportunity Cost of Capital To find the opportunity cost of capital, multiply the opportunity interest rate (e.g. what the capital could earn elsewhere) times the average total asset value. For I.M. Farmer: $725,750×8% = $58,060

43. Return to Labor and Management

44. Return to Labor

45. Return to Management

46. Change in Owner Equity • Retained farm earnings: the part of farm earnings, after taxes and personal withdrawals, that is retained for use in the farm business • A positive retained farm earnings increases owner equity • If taxes and living expenses are greater than total earnings, owner equity will fall

47. Figure 6-3Relation between net farm income and change in equity

48. Summary An income statement organizes and summarizes revenue and expenses for an accounting period. Net farm income, or profit, is a dollar amount, whereas profitability relates profits to the size of the business.