Farm Income Statement Analysis

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Farm Income Statement Analysis

• AAE 320
• Paul D. Mitchell

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Goal

• Overview accounting income statement as it
  pertains to agricultural operations
• How to prepare and/or read one
• How to use one to calculate rates of return

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Income Statement

• Income Statement Record of revenues and expenses
  over a period of time
• Balance Sheet Statement of assets, liabilities
  and equity at a point in time
• Other names for an income statement
• Operating Statement
• Business/Farm Profit and Loss Statement
• Question Did you make money last year?

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Revenue

• Account for all business revenue earned during
  the period cash and non-cash
• Crop sales
• Feeder livestock sales
• Crop and Livestock product sales
• Government program payments, including crop
  insurance and disaster payments
• Anything you sell!

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Non-Cash Revenue

• Inventories changes for commodities ready for
  sale
• Grain, feeder livestock
• Accrual basis value of ending inventory minus
  value of beginning inventory
• Accounts receivable ending balance minus
  beginning balance
• Non-cash payments in kind, trades, custom harvest
  arrangements, etc.

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Revenue Special Cases

• Gain/Loss from sale of culled breeding livestock
  or milk cows
• Normal part of production process, not treat as
  gain/loss from sale of a capital asset
• Change in value of raised breeding livestock or
  milk cows
• Treat increase in value of a raised heifer calf
  becoming a cow or milk cow (or part way along
  this process) as an increase in revenue

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Revenue Special Cases

• Gains or Losses on Sales of Capital Assets are
  treated as revenue
• Land Selling Price minus Cost
• Only change due to price changes
• Depreciable Assets Selling Price minus Book
  Value (Book value is value according to your
  depreciation schedule)
• Changes due to price changes and errors in
  estimating depreciation
• This adjusts revenue for errors in depreciation,
  which are very common

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Expenses

• Account for all business expenses incurred during
  the period cash and non-cash
• Purchased inputs fertilizer, seed, fuel,
  chemicals, feeder livestock, feed, etc.
• Labor and services
• Repairs and maintenance
• Property taxes, insurance, etc.
• Everything you buy for the farm!!!

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Non-Cash Expenses

• Depreciation
• All capital assets (buildings, tractors, etc.)
• Breeding livestock, milk cows, perennial crops
• Cost of production to account for, even if you
  dont pay cash
• Accounts Payable
• Ending accounts payable balance minus beginning
  accounts payable balance

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Prepaid Expenses

• Expenses from previous period for production
  during this period
• Common examples fertilizer, seed, feed etc.
  bought in previous year for this year
• Pay this year for prepaid expenses you paid last
  year for use this year
• Put off to next year prepaid expense you paid
  this year for use next year
• Expenses for This Year Prepaid Expense Last
  Year Prepaid Expense This Year

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Accrued Expenses

• Cash interest paid
• Add accrued interest owed
• Subtract interest prepaid
• Property taxes paid
• Add accrued taxes owed
• Subtract taxes prepaid
• Income taxes
• Should estimate, but that very difficult
• Do Income Statement as pre-tax income
• Do after-tax Income Statement later after pay
  taxes

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Income Statement

• General format given here, are many variations in
  use
• Main Idea
• Revenue Expenses Net Farm Income from
  Operations
• Add gain/loss net gain from sale of capital
  assets Net Farm Income
• Some like to keep interest payments separate so
  can see income from production activities vs
  financing activities

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Accrual Adjustment of Cash Basis Income Statement

• Not everyone does accrual accounting (the
  business standard)cash accounting still the most
  common
• Accrual accounting more accurate/useful for
  decision makingputs costs in year used and
  receive accompanying revenue, but more complex
  and time consuming
• Cash accounting simple and has advantages for
  income tax purposes, so more popular
• Cash accounting can be misleading, so recommend
  those using cash accounting to develop an accrual
  adjusted net farm income

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Accrual Adjusted Net Farm Income

• Cash Net Income (pre-tax) Cash Receipts Cash
  Disbursements
• Depreciation Gain/Loss Capital Sale
• Accrual adjustments to Cash Receipts
• Adjust for Inventory Changes (e.g., grain and
  feeder livestock)
• Cash Receipts Value of Ending Inventory Value
  of Beginning Inventory Gross Revenues

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Accrual Adjusted Cash Disbursements to get
Operating Expenses

• Many more accrual adjustments of cash
  disbursements to generate operating expenses
• Goal to get costs accounted for in the year they
  were used to produce revenue, not the year they
  actually spent
• Accounts Payable, Prepaid Expenses, Unused
  Supplies, Accrued Expenses

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Accrual Adjusted Cash Disbursements

• Cash Disbursements
• Ending Accounts Payable
• Beginning Accounts Payable
• Ending Accrued Expenses
• Beginning Accrued Expenses
• Ending Prepaid Expenses
• Beginning Prepaid Expenses
• Ending Unused Supplies (fuel, chems, seed,
  fert)
• Beginning Unused Supplies (fuel, chems, seed,
  fert)
• Operating Expenses

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Accrual Adjusted Net Farm Income

• Cash Net Income (pre-tax)
• Cash Receipts Cash Disbursements
• Depreciation Gain/Loss Capital Sale
• Accrual Adjusted Net Income (pre-tax)
• Gross Revenues Operating Expenses
• Depreciation Gain/Loss Capital Sale
• Main point use accrual adjustments to cash
  receipts and disbursements

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Main Point

• Most farmers use cash accounting, commonly to
  file tax forms
• Farmers commonly move costs between years to
  reduce taxes
• Income statements adjust this tax income for
  more accurate measurement of income
• Pay for costs in the year actually used, not in
  tax year the cost deducted from taxable income

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Example to illustrate

• If 2008 a good year, pre-buy more inputs
  (fertilizer, seed) in 2008 for use in 2009 to
  lower 2008 taxes
• Same trick with accounts payable in 2008 payoff
  in 2008 to reduce 2008 taxes, not wait until 2009
  to pay off
• Income statement adjust for these practices Pay
  for costs in year used to make income, even if
  actually bought in different year How?
• Ending Prepaid Expenses Beginning Prepaid
  Expenses Ending Accounts Payable Beginning
  Accounts Payable

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Main Point Summary

• How adjust tax income for more accurate income
  statement
• Adjust cash receipts for inventory changes
• Adjust cash disbursements for accounts payable,
  accrued expenses, prepaid expenses, and input
  inventory changes

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Uses for Income Statement

• See if made a business profit or had a loss, but
  really want to know profitability
• Profitability normalize for size to see if
  efficient use of resources to produce income
• Five Measures commonly used
• Net Farm Income
• Net Farm Income from Operations
• Rate of Return on Assets
• Rate of Return on Equity
• Operating Profit Ratio

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Net Farm Income

• We already did this oneits what the income
  statement produces!!!
• This income covers your
• Unpaid Labor (yours and your familys)
• Management time and effort (yours and your
  familys)
• Return on your equity
• Will remove value of Unpaid Labor and Management
  from Net Farm Income to calculate the other
  measures

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Net Farm Income from Operations

• Adjust Net Farm Income
• 1) Add Interest Expenses back in
• 2) Subtract (or do not include) Gain/Loss from
  Sale of Capital Assets
• First adjustment so can determine income
  generated by all farm assets (both own equity and
  external equity financed)
• Second adjustment so can determine income
  generated by productive activities, not change in
  asset values (remove investment income)

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Rate of Return on Assets

• Use net far income to estimate the rate of return
  on assets
• Also called Return to Capital, Return on
  Investment
• Need to adjust farm income for reasons to be
  explained
• Use Balance Sheet to find the average assets
  during the accounting period
• This why Farm Balance Sheet and Income Statement
  go together

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Rate of Return on Assets

• Want return on all assets, those financed with
  debt and with equity, so need to add interest
  expenses back into farm income
• Not include gain/loss from sale of capital
  assets, as this not a source of returns due to
  productivity (but errors in depreciation)
• Not include unpaid labor and management so need
  to remove these from net farm income How? Often
  use opportunity cost

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Rate of Return on Assets

• Rate of Return on Assets (Return on Assets /
  Average Assets) x 100
• Return on Assets Net Farm Income from Income
  Statement with adjustments
• 1) Add Interest Expenses back in
• 2) Subtract (or do not include) Gain/Loss from
  Sale of Capital Assets
• 3) Subtract opportunity cost of unpaid Labor and
  Management time and effort
• Net Farm Income from Operations is whats left
  after the 1st and 2nd adjustment

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Return on Assets

• Remember Net Farm Income from Income Statement
  everything left had to cover
• Unpaid Labor and Management time and effort or
  you and your family, plus Return on your equity
• For Return on Assets need to estimate the costs
  for unpaid Labor and Management time
• What it would cost to hire someone to do all the
  currently unpaid labor and management?
• You and family are worth as much as you could
  make at your next best alternatives, i.e., your
  opportunity costs

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Return on Assets

• Main point Its easy to add Interest Expenses
  back in and not include Gain/Loss from Sale of
  Capital Assets
• Removing costs of labor and management are
  somewhat arbitrary, but important
• What ever costs you choose will change your
  estimated Return on Assets
• Many just use Net Farm Income from Operations and
  ignore unpaid labor and management
• Know these issues before you compare with other
  businesses and with market returns

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Rate of Return on Assets

• Rate of Return on Assets (Return on Assets /
  Average Assets) x 100
• We talked lots about the Numerator!
• Denominator Average Assets average assets
  during the accounting period
• Usually use average of beginning and ending
  Balance Sheet total assets
• Which basis for asset valuation cost or market?
• Usually market basis so can compare farms and
  compare to liquidating and getting market rates
• Cost basis to look at your trend over years

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FFSC recommendations/caveats

• 1) Use net farm income from operations
• (no gain/loss from capital assets sales)
• 2) Opportunity costs for labor and management are
  estimates, different costs give different answers
• 3) Comparing rates of return only if done in same
  way, especially asset valuation
• Market basis to compare farms
• Cost basis to see your trends over time
• 4) Do not include non-farm assets and income
• 5) This estimates the average rate of return
  (over all invested), not the marginal rate of
  return (on the last invested) not proper to
  use when deciding investment in additional farm
  assets

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Final Comment on Return on Assets

• Probably the most difficult part is subtracting
  opportunity costs for unpaid labor and time
• Hard to estimate
• If you dont subtract them, then you get a higher
  rate of return on assets and bragging rights
• Better to include these costs and think, After I
  pay myself (and my family), what rate of return
  do I earn on the assets (and my equity)?
• Can use Return on Assets to calculate return on
  equity and profit margin, so do it right

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Rate of Return on Equity

• Just like rate of return on assets, except now
  you do not include the interest costs, since this
  was the farm income used to pay for debt equity
• Rate of Return on Equity (Return on Equity /
  Average Equity) x 100
• Average Equity average of equity at the
  beginning and end of the period, as obtained from
  the farm Balance Sheet

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Return on Equity

• Return on Equity Net Farm Income from Income
  Statement with adjustments
• 1) Subtract (or do not include) Gain/Loss from
  Sale of Capital Assets
• 2) Subtract opportunity cost of unpaid Labor and
  Management time and effort
• Alternative 1 Return on Assets Interest
  Expenses
• Alternative 2 Net Farm Income from Operations
• Interest Expenses
• Opportunity Cost of Labor and Management

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Return on Equity and Assets

• Only difference between return on equity and
  return on assets is interest expenses
• Interest expenses depend on the interest rate
• If Rate of Return on Assets gt Interest Rate,
• Rate of Return on Equity gt Rate of Return on
  Assets
• If Rate of Return on Assets lt Interest Rate,
• Rate of Return on Equity lt Rate of Return on
  Assets
• Main point if rate of return on assets exceeds
  the interest rate (benefit exceeding the cost),
  then the extra margin generated from use of
  external funds goes to increase rate of return on
  equity

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Operating Profit Margin Ratio(or Simply Profit
Margin)

• Operating profit as percent of revenue
• Operating profit Return on Assets
• Operating Profit Margin Ratio
• Operating Profit / Total Revenue
• Return on Assets / Total Revenue
• Low Profit Margin improve ratio first (by
  lowering costs) before expansion
• High Profit Margin expansion may make sense

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Summary

• How to develop an Income Statement
• Accrual Accounting
• Accrual Adjusted Cash Accounting
• Measures from Income Statement
• Net Farm Income
• Rate of Return on Assets
• Rate of Return on Equity
• Profit Margin
• Look at example rates and margins
• Look at example income statement

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Rates of Return in Dairy

• Rate of Return on Assets ROROA
• Rate of Return on Equity ROROE
• UW Center for Dairy Profitability
• http//cdp.wisc.edu/pdf/02bench.pdf
• Two methods
• Assets at Cost and use Tax Depreciation
• Assets at Market Value and use Economic
  Depreciation
• Does not include cost of unpaid labor and
  management or opportunity cost of owner equity

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Average Profitability in WI Dairy
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ROROA in WI Dairy
Assets at Market Value and Economic Depreciation
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Other States and Farm Types

• Illinois 2004 ROROA and ROROE
• Grain 6.2 7.1
• Hog 13.4 19.2
• Beef 2.9 2.6
• Dairy 9.6 11.2
• MN Farm Bus. Mngmt. Assoc. 2004
• 8.0 10.9 17.6 profit margin
• Range Lowest 20 farms -2.7, -18.0, -8.0
• Highest 20 farms 13.4, 20.8, 26.0

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Other States and Farm Types

• Iowa 1990-1998 average
• ROROA ROROE Margin
• Grain 7.3 6.0 22.3
• Hog 7.4 6.3 20.9
• Fed Beef 6.0 4.6 23.1
• Cow-Calf 4.5 2.6 16.0
• Dairy 7.6 7.5 21.1

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Other States and Farm Types

• Iowa 1990-1998 average
• ROROA ROROE Margin
• All owned 5.6 4.4 20.7
• Own/Rent 6.8 6.5 23.3
• Cash Rent 7.8 7.4 14.2
• Crop Share 9.5 9.9 18.9
• Lstock Share 6.4 4.5 17.2

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Example from FFSC Publication

• Farm Financial Standards Council (FFSC) has large
  publication (200 pages) explaining farm
  financial statements, with an appendix of
  extended examples
• Web link http//www.ffsc.org/guidelin.htm
• Posted copy on class homepage
• Will go through handout in class

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Balance Sheet Example from FFSC
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Income Statement Example from FFSC
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Income Statement Example from FFSC
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Farm Accounting Programs(from Jenny Vanderlin,
UW CDP)

• AAIMS Agricultral Accounting and Management
  Information System
• UW CDP developed and CDP, UWEX supports, cheap
  (150) for dairy only
• AgManager by AgriSolutions
• General farm accounting, Badgerland FCS
• Redwing sells CenterPoint and Perception
• More expensive, used by ag accounting firms
• CenterPoint is newer, more for farmers

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Farm Accounting Programs(from Jenny Vanderlin,
UW CDP)

• Several Others Farm Fund, PeachTree,
  QuickBooks, Quicken, MoneyWorks
• CDP and UIWEX do presentations and workshops for
  farmers to learn more about these
• Heart of the Farm, Annies Project
• UWEX as requested

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WI Farm Management Associations

• Fox Valley Farm Management
• Appleton, WI [phone]
• Lakeshore Farm Management
• http//www.lakeshorefarmmanagement.com/
• Valders, WI [phone]
• Farm Credit Services http//www.farmcredit.com/
• GreenStone (Appleton) [phone]
• Badgerland (Baraboo) [phone]
• North Central Wisconsin (Wausau) [phone]
• AgStar Financial Services (Mankato, MN)
• UWEX County Agents

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More Information

• Web pages I gave with Balance Sheets
• UWEX Center for Dairy Profitability
• FarmDOC IL Extension
• Center for Farm Financial Management MN EX
• AgDecision Maker IA Extension
• Damona Doye at Oklahoma State University
• Farm Financial Standards Council
• Agriculture Financial Advisor (AgFA) by CDP and
  UWEX
• Other states have comparable groups