2.2.11 The Five Cs of Credit
2.2.12 Credit and Risk
2.2.1 Financial and Managerial Accounting
2.2.2 The Importance of Accounting Information
2.2.3 Fixed and Variable Costs
2.2.4 Budgets and Goals
2.2.5 Analyzing Financial Statements
2.2.6 Budgets and the Use in Agribusiness
2.2.7 Cash Flow Budgeting in Agribusiness
2.2.8 Net Worth Statements in Agribusiness
2.2.9 Important Financial Statements for Agribusiness
Agribusiness Budgeting and Accounting
Overview
Financial and Managerial Accounting
Learning Objectives
4a Differentiate financial and managerial accounting.
What is Accounting?
Accounting is the process of organizing, analyzing, and communicating financial information that is used for decision-making. Financial information is typically prepared by accountants—those trained in the specific techniques and practices of the profession. This section explores many of the topics and techniques related to the accounting profession because a solid understanding of accounting can serve as a useful resource for any career. In fact, it is hard to think of a profession where a foundation in the principles of accounting would not be beneficial. While students may directly apply the knowledge gained in this course to continue their education in accounting, others may pursue different career paths in business. Therefore, one of the goals of this section is to provide a solid understanding of how financial information is prepared and used in the workplace, specifically in agribusiness.
A traditional adage states that “accounting is the language of business.” While that is true, you can also say that “accounting is the language of life.” At some point, most people will make a decision that relies on accounting information. For example, you may have to decide whether it is better to lease or buy a vehicle. Likewise, a college graduate may have to decide whether it is better to take a higher-paying job in a bigger city (where the cost of living is also higher) or a job in a smaller community where both the pay and cost of living may be lower. In a professional setting, a theater manager may want to know if the most recent play was profitable. Similarly, the owner of the local plumbing business may want to know whether it is worthwhile to pay an employee to be “on call” for emergencies during off-hours and weekends. Whether personal or professional, accounting information plays a vital role in all of these decisions.
You may have noticed that the decisions in these scenarios would be based on factors that include both financial and nonfinancial information. For instance, when deciding whether to lease or buy a vehicle, you would consider not only the monthly payments but also such factors as vehicle maintenance and reliability. The college graduate considering two job offers might weigh factors such as working hours, ease of commuting, and closeness to existing friends and family. The theater manager would analyze the proceeds from ticket sales and sponsorships, as well as the expenses for production of the play and operating the concessions. In addition, the theater manager should consider how the financial performance of the play might have been influenced by the marketing of the play, the weather during the performances, and other factors such as competing events during the time of the play. the owner of the local plumbing business would consider nonfinancial factors in the decision, in addition to the added cost of having an employee “on call” during evenings and weekends; for instance, if there are no other plumbing businesses that offer services during evenings and weekends, offering emergency service might give the business a strategic advantage that could increase overall sales by attracting new customers. All of these factors, both financial and nonfinancial, are relevant to the possible financial performance in each scenario.
Financial Accounting
Financial accounting measures the financial performance of an organization using standard conventions to prepare and distribute financial reports. Financial accounting is used to generate information for stakeholders outside of an organization, such as owners, stockholders, lenders, and governmental entities such as the Securities and Exchange Commission (SEC) and the Internal Revenue Service (IRS).
Managerial Accounting
Managerial accounting employs both financial and nonfinancial information as a basis for making decisions within an organization for the purpose of equipping decision makers to set and evaluate business goals. Managerial accounting allows decision makers to determine what information is needed, and how to analyze and communicate that information, so they can make a particular business decision. This information tends to be used internally, for such purposes as budgeting, pricing, and determining production costs. Since the information is generally used internally, you do not see the same need for financial oversight in an organization’s managerial data.
Accounting Oversight
There are governmental and organizational entities that oversee the accounting processes and systems that are used in financial accounting. These entities include organizations such as the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants (AICPA), and the Public Company Accounting Oversight Board (PCAOB). The PCAOB was created after several major cases of corporate fraud, leading to the Sarbanes-Oxley Act of 2002, known as SOX. If you choose to pursue more advanced accounting courses, especially auditing courses, you will address the SOX in much greater detail. For now, it is not necessary to go into greater detail about the mechanics of these organizations or other accounting and financial legislation. You just need to have a basic understanding that they function to provide a degree of protection for those outside of the organization who rely on the financial information produced by a business.
Both Forms are Useful
Whether or not you aspire to become an accountant, understanding financial and managerial accounting is valuable and necessary for practically any career you will pursue. Management of a car manufacturer, for example, would use both financial and managerial accounting information to help improve the business. Financial accounting information is valuable as it measures whether or not the company is financially successful. Knowing this provides management with an opportunity to repeat activities that have proven effective and to make adjustments in areas in which the company has underperformed. Managerial accounting information is likewise valuable. Managers of the car manufacturer may want to know, for example, how much scrap is generated from a particular area in the manufacturing process. While identifying and improving the manufacturing process (i.e., reducing scrap) helps the company financially, it may also help improve other areas of the production process that are indirectly related, such as poor quality and shipping delays.
Attributions
Title Image: "Analyzing Financial Data" by Dave Dugdale, Wikimedia Commons is licensed under CC BY-SA 2.0
Description: Closeup of calculator, hand, pen and financial statement.
"Principles of Accounting, Volume 1: Financial Accounting" by Mitchell Franklin, Patty Graybeal, Dixon Cooper, OpenStax is licensed under CC BY-NC-SA 4.0
Access for free at https://openstax.org/books/principles-financial-accounting/pages/1-1-explain-the-importance-of-accounting-and-distinguish-between-financial-and-managerial-accounting
The Importance of Accounting Information
Learning Objectives
4b Explain basic accounting considerations.
Accounting and Decision Making
The ultimate goal of accounting is to provide information that is useful for decision-making. Users of accounting information are generally divided into two categories: internal and external.
Internal users are those within an organization who use financial information to make day-to-day decisions. Internal users include managers and other employees who use financial information to confirm past results and help make adjustments for future activities.
External users are those outside of the organization who use the financial information to make decisions or to evaluate an entity’s performance. For example, investors, financial analysts, loan officers, governmental auditors, such as IRS agents, and an assortment of other stakeholders are classified as external users, while still having an interest in an organization’s financial information.
Characteristics, Users, and Sources of Financial Accounting Information
Financial accounting is one of the broad categories in the study of accounting. While some industries and types of organizations have variations in how the financial information is prepared and communicated, accountants generally use the same methodologies—called accounting standards—to prepare the financial information.
Financial information is primarily communicated through financial statements, which include the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows and Disclosures. These financial statements ensure the information is consistent from period to period and generally comparable between organizations. The conventions also ensure that the information provided is both reliable and relevant to the user.
Organizations measure financial performance in monetary terms. In the United States, the dollar is used as the standard measurement basis. Measuring financial performance in monetary terms allows managers to compare the organization’s performance to previous periods, to expectations, and to other organizations or industry standards.
Virtually every activity and event that occurs in a business has an associated cost or value and is known as a transaction. Part of an accountant’s responsibility is to quantify these activities and events. In this course you will learn about the many types of transactions that occur within a business. You will also examine the effects of these transactions, including their impact on the financial position of the entity.
Accountants use formal accounting standards in financial accounting. These accounting standards are referred to as generally accepted accounting principles (GAAP) and are the common set of rules, standards, and procedures that publicly traded companies must follow when composing their financial statements. The Financial Accounting Standards Board (FASB)—an independent, nonprofit organization that sets financial accounting and reporting standards for both public and private sector businesses in the United States—uses the GAAP guidelines as its foundation for its system of accepted accounting methods and practices, reports, and other documents.
Accountants often use computerized accounting systems to record and summarize the financial reports, which offer many benefits. The primary benefit of a computerized accounting system is the efficiency by which transactions can be recorded and summarized, and financial reports prepared. In addition, computerized accounting systems store data, which allows organizations to easily extract historical financial information.
Common computerized accounting systems include QuickBooks, which is designed for small organizations, and SAP, which is designed for large and/or multinational organizations. QuickBooks is popular with smaller, less complex entities. It is less expensive than more sophisticated software packages, such as Oracle or SAP, and the QuickBooks skills that accountants developed at previous employers tend to be applicable to the needs of new employers, which can reduce both training time and costs spent on acclimating new employees to an employer’s software system. Also, being familiar with a common software package such as QuickBooks helps provide employment mobility when workers wish to reenter the job market.
While QuickBooks has many advantages, once a company’s operations reach a certain level of complexity, it will need a more advanced software package or platform, such as Oracle or SAP, which is then customized to meet the unique informational needs of the entity.
Financial accounting information is mostly historical in nature, although companies and other entities also incorporate estimates into their accounting processes. For example, you will learn how to use estimates to determine bad debt expenses or depreciation expenses for assets that will be used over a multiyear period. That is, accountants prepare financial reports that summarize what has already occurred in an organization. This information provides what is called feedback value. The benefit of reporting what has already occurred is the reliability of the information. Accountants can, with a fair amount of confidence, accurately report the financial performance of the organization related to past activities. The feedback value offered by the accounting information is particularly useful to internal users. That is, reviewing how the organization performed in the past can help managers and other employees make better decisions about and adjustments to future activities.
Financial information has limitations as a predictive tool. Business involves a large amount of uncertainty, and accountants cannot predict how the organization will perform in the future. However, by observing historical financial information, users of the information can detect patterns or trends that may be useful for estimating the company’s future financial performance.
Collecting and analyzing a series of historical financial data is useful to both internal and external users. For example, internal users can use financial information as a predictive tool to assess whether the long-term financial performance of the organization aligns with its long-term strategic goals. External users also use the historical pattern of an organization’s financial performance as a predictive tool. For example, when deciding whether to loan money to an organization, a bank may require a certain number of years of financial statements and other financial information from the organization. The bank will assess the historical performance in order to make an informed decision about the organization’s ability to repay the loan and interest (the cost of borrowing money). Similarly, a potential investor may look at a business’s past financial performance in order to assess whether or not to invest money in the company. In this scenario, the investor wants to know if the organization will provide a sufficient and consistent return on the investment. In these scenarios, the financial information provides value to the process of allocating scarce resources (money). If potential lenders and investors determine the organization is a worthwhile investment, money will be provided; if all goes well, those funds will be used by the organization to generate additional value at a rate greater than the alternate uses of the money.
Characteristics, Users, and Sources of Managerial Accounting Information
As you’ve learned, managerial accounting information is different from financial accounting information in several respects. The business environment is constantly changing, and managers and decision makers within organizations need a variety of information in order to view or assess issues from multiple perspectives. Since managerial accounting often includes strategic or competitive decisions, it is often closely protected. Most managerial accounting activities are conducted for internal uses and applications; therefore, managerial accounting is not prepared using a comprehensive, prescribed set of conventions similar to those required by financial accounting. This is because managerial accountants provide managerial accounting information that is intended to serve the needs of internal, rather than external, users. In fact, managerial accounting information is rarely shared with those outside of the organization.
Accountants must be adaptable and flexible in their ability to generate the necessary information for management decision-making. For example, information derived from a computerized accounting system is often the starting point for obtaining managerial accounting information. But accountants must also be able to extract information from other sources (internal and external) and analyze the data using mathematical, formula-driven software (such as Microsoft Excel). Examples of other decisions that require management accounting information include whether an organization should repair or replace equipment, make products internally or purchase the items from outside vendors, and hire additional workers or use automation.
Management accounting information as a term encompasses many activities within an organization. Preparing a budget, for example, allows an organization to estimate the financial performance for the upcoming year or years and plan for adjustments to scale operations according to the projections. Accountants often lead the budgeting process by gathering information from internal (estimates from the sales and engineering departments, for example) and external (trade groups and economic forecasts, for example) sources. All of this data is then compiled and presented to decision makers within the organization.
As you have learned, management accounting information uses both financial and nonfinancial information. This is important because there are situations in which a purely financial analysis might lead to one decision, while considering nonfinancial information might lead to a different decision. For example, suppose a financial analysis indicates that a particular product is unprofitable and should no longer be offered by a company. If the company fails to consider that customers also purchase a complementary good, the company may be making the wrong decision. For example, assume that you have a company that produces and sells both computer printers and the replacement ink cartridges. If the company decided to eliminate the printers, then it would also lose the cartridge sales. The elimination of one component, such as printers, has led customers, in the past, to switch producers for their computers and other peripheral hardware. In the end, an organization needs to consider both the financial and nonfinancial aspects of a decision, and sometimes the effects are not intuitively obvious at the time of the decision.
Overview
Figure 2.2.2a offers an overview of some of the differences between financial and managerial accounting.
Attributions
"Principles of Accounting, Volume 1: Financial Accounting" by Mitchell Franklin, Patty Graybeal, Dixon Cooper, OpenStax is licensed under CC BY-NC-SA 4.0
Access for free at https://openstax.org/books/principles-financial-accounting/pages/1-2-identify-users-of-accounting-information-and-how-they-apply-information
Fixed and Variable Costs
Learning Objectives
4i Describe the fixed and variable expenses.
Fixed Costs
A fixed cost is an unavoidable operating expense that does not change in total over the short term, even if a business experiences variation in its level of activity. Table 2.2.3a illustrates the types of fixed costs for merchandising, service, and manufacturing organizations.
| Type of Business | Fixed Cost |
|---|---|
| Merchandising | Rent, insurance, managers’ salaries |
| Manufacturing | Property taxes, insurance, equipment leases |
| Service | Rent, straight-line depreciation, administrative salaries, and insurance |
We have established that fixed costs do not change in total as the level of activity changes, but what about fixed costs on a per-unit basis? Let’s examine Tony’s screen-printing company to illustrate how costs can remain fixed in total but change on a per-unit basis.
Tony operates a screen-printing company, specializing in custom T-shirts. One of his fixed costs is his monthly rent of $1,000. Regardless of whether he produces and sells any T-shirts, he is obligated under his lease to pay $1,000 per month. However, he can consider this fixed cost on a per-unit basis, as shown in Figure 2.2.3a.
Tony’s information illustrates that, despite the unchanging fixed cost of rent, as the level of activity increases, the per-unit fixed cost falls. In other words, fixed costs remain fixed in total but can increase or decrease on a per-unit basis.
Two specialized types of fixed costs are committed fixed costs and discretionary fixed costs. These classifications are generally used for long-range planning purposes and are covered in upper-level managerial accounting courses, so they are only briefly described here.
Committed fixed costs are fixed costs that typically cannot be eliminated if the company is going to continue to function. An example would be the lease of factory equipment for a production company.
Discretionary fixed costs generally are fixed costs that can be incurred during some periods and postponed during other periods but which cannot normally be eliminated permanently. Examples could include advertising campaigns and employee training. Both of these costs could potentially be postponed temporarily, but the company would probably incur negative effects if the costs were permanently eliminated. These classifications are generally used for long-range planning purposes.
In addition to understanding fixed costs, it is critical to understand variable costs, the second fundamental cost classification. A variable cost is one that varies in direct proportion to the level of activity within the business. Typical costs that are classified as variable costs are the cost of raw materials used to produce a product, labor applied directly to the production of the product, and overhead expenses that change based upon activity. For each variable cost, there is some activity that drives the variable cost up or down. A cost driver is defined as any activity that causes the organization to incur a variable cost. Examples of cost drivers are direct labor hours, machine hours, units produced, and units sold. Table 2.2.3b provides examples of variable costs and their associated cost drivers.
| Variable Cost | Cost Driver | |
|---|---|---|
| Merchandising | Total monthly hourly wages for sales staff | Hours business is open during month |
| Manufacturing | Direct materials used to produce one unit of product | Number of units produced |
| Service | Cost of laundering linens and towels | Number of hotel rooms occupied |
Variable Costs
Unlike fixed costs that remain fixed in total but change on a per-unit basis, variable costs remain the same per unit, but change in total relative to the level of activity in the business. Revisiting Tony’s T-Shirts, Figure 2.2.3b shows how the variable cost of ink behaves as the level of activity changes.
As Figure 2.2.3b shows, the variable cost per unit (per T-shirt) does not change as the number of T-shirts produced increases or decreases. However, the variable costs change in total as the number of units produced increases or decreases. In short, total variable costs rise and fall as the level of activity (the cost driver) rises and falls.
Distinguishing between fixed and variable costs is critical because the total cost is the sum of all fixed costs (the total fixed costs) and all variable costs (the total variable costs). In every business situation, managers should determine their total costs both per unit of activity and in total by combining their fixed and variable costs together. The graphic in Figure 2.2.3c illustrates the concept of total costs.
Remember that the reason that organizations take the time and effort to classify costs as either fixed or variable is to be able to control costs. When they classify costs properly, managers can use cost data to make decisions and plan for the future of the business.
Boeing Example
If you’ve ever flown on an airplane, there’s a good chance you know Boeing. The Boeing Company generates around $90 billion each year from selling thousands of airplanes to commercial and military customers around the world. It employs around 200,000 people, and it’s indirectly responsible for more than a million jobs through its suppliers, contractors, regulators, and others. Its main assembly line in Everett, WA is housed in the largest building in the world, a colossal facility that covers nearly a half-trillion cubic feet. Boeing is, simply put, a massive enterprise.
And yet, Boeing’s managers know the exact cost of everything the company uses to produce its airplanes: every propeller, flap, seat belt, welder, computer programmer, and so forth. Moreover, they know how those costs would change if they produced more airplanes or fewer. They also know the price at which they sold each plane and the profit made from each sale. Boeing’s executives expect their managers to know this information, in real time, so the company can make useful decisions. See Table 2.2.3c for a picture of how cost information affects business decisions.
| Decision | Cost Information |
|---|---|
| Discontinue a product line | Variable costs, overhead directly tied to product, potential reduction in fixed costs |
| Add second production shift | Labor costs, cost of fringe benefits, potential overhead increases (utilities, security personnel) |
| Open additional retail outlets | Fixed costs, variable operating costs, potential increases in administrative expenses at corporate headquarters |
Attributions
"Principles of Accounting, Volume 2: Managerial Accounting" by Mitchell Franklin, Patty Graybeal, Dixon Cooper, OpenStax is licensed under CC BY-NC-SA 4.0
Access for free at https://openstax.org/books/principles-managerial-accounting/pages/2-2-identify-and-apply-basic-cost-behavior-patterns
Budgets and Goals
Learning Objectives
4g Discuss the importance of budgets and written goals.
The Budget—For Planning and Control
Time and money are scarce resources to all individuals and organizations; the efficient and effective use of these resources requires planning. Planning alone, however, is insufficient. Control is also necessary to ensure that plans are actually carried out.
A budget is a plan showing the company's objectives and how management intends to acquire and use resources to attain those objectives. And it is a tool that managers use to control the use of scarce resources.
The period covered by a budget varies according to the nature of the specific activity involved. Cash budgets may cover a week or a month; sales and production budgets may cover a month, a quarter, or a year; and the general operating budget may cover a quarter or a year.
Companies, nonprofit organizations, and governmental units use many different types of budgets. Responsibility budgets are designed to judge the performance of an individual segment or manager. Capital budgets evaluate long-term capital projects, such as the addition of equipment or the relocation of a plant.
This section focuses on the master budget, which consists of a planned operating budget and a financial budget. The planned operating budget helps to plan future earnings and results in a projected income statement. The financial budget helps management plan the financing of assets and results in a projected balance sheet.
The budgeting process involves planning for future profitability because earning a reasonable return on resources used is a primary company objective. A company must devise some method to deal with the uncertainty of the future. A company that does no planning whatsoever chooses to deal with the future by default and can react to events only as they occur. Most businesses, however, devise a blueprint for the actions they will take given the foreseeable events that may occur, and that blueprint is generally the budget.
A budget
- shows management's operating plans for the coming periods;
- formalizes management's plans in quantitative terms;
- forces all levels of management to think ahead, anticipate results, and take action to remedy possible poor results;
- and may motivate individuals to strive to achieve stated goals.
Companies can use budget-to-actual comparisons to evaluate individual performance. For instance, the standard variable cost of producing a personal computer at IBM is a budget figure. This figure can be compared with the actual cost of producing personal computers to help evaluate the performance of the personal computer production managers and employees.
Many other desired benefits result from the preparation and use of budgets, including:
- Businesses can better coordinate their activities.
- Managers can become aware of other managers' plans.
- Employees can become more cost conscious and try to conserve resources.
- The company can review its organization plan and changes it when necessary.
- Managers can foster a vision that otherwise might not be developed. The planning process that results in a formal budget provides an opportunity for various levels of management to think through and commit future plans to writing. In addition, a properly prepared budget allows management to follow the management-by-exception principle by devoting attention to results that deviate significantly from planned levels.
Failing to budget because of the uncertainty of the future is a poor excuse for not budgeting. In fact, the less stable the conditions, the more necessary and desirable budgeting is, although the process becomes more difficult. Obviously, stable operating conditions permit greater reliance on past experience as a basis for budgeting. Remember, however, that budgets involve more than a company's past results. Budgets also consider a company's future plans and express expected activities. As a result, budgeted performance is more useful than past performance as a basis for judging actual results.
Management and the Budget
A budget should describe management's assumptions relating to
- the state of the economy over the planning horizon;
- plans for adding, deleting, or changing product lines;
- the nature of the industry's competition;
- and the effects of existing or possible government regulations.
If these assumptions change during the budget period, management should analyze the effects of the changes and include this in an evaluation of performance based on actual results.
Management should frequently compare accounting data with budgeted projections during the budget period and investigate any differences. Budgeting, however, is not a substitute for good management. Instead, the budget is an important tool of managerial control. Managers make decisions in budget preparation that serve as a plan of action.
Accountant Involvement
The accounting system and the budget are closely related. Budgets are quantitative plans for the future. However, they are based mainly on past experience adjusted for future expectations. Thus, accounting data related to the past plays an important part in budget preparation. The details of the budget must agree with the company's ledger accounts. In turn, the accounts must be designed to provide the appropriate information for preparing the budget, financial statements, and interim financial reports to facilitate operational control.
Within a participatory budgeting process, accountants should be compilers or coordinators of the budget, not preparers. They should be on hand during the preparation process to present and explain significant financial data. Accountants must identify the relevant cost data that enables management's objectives to be quantified in dollars. Accountants are responsible for designing meaningful budget reports. Also, accountants must continually strive to make the accounting system more responsive to managerial needs. That responsiveness, in turn, increases confidence in the accounting system.
Overcoming Budget Stigma
The term budget has negative connotations for many employees. Often in the past, management has imposed a budget from the top without considering the opinions and feelings of the personnel affected. Such a dictatorial process may result in resistance to the budget. A number of reasons may underlie such resistance, including lack of understanding of the process, concern for status, and an expectation of increased pressure to perform. Employees may believe that the performance evaluation method is unfair or that the goals are unrealistic and unattainable. They may lack confidence in the way accounting figures are generated or may prefer a less formal communication and evaluation system. Often these fears are completely unfounded, but if employees believe these problems exist, it is difficult to accomplish the objectives of budgeting.
Problems encountered with such imposed budgets have led accountants and management to adopt participatory budgeting. Participatory budgeting means that all levels of management responsible for actual performance actively participate in setting operating goals for the coming period. Managers and other employees are more likely to understand, accept, and pursue goals when they are involved in formulating them.
Conditions that Affect the Budget
Budgeting involves the coordination of financial and nonfinancial planning to satisfy organizational goals and objectives. No foolproof method exists for preparing an effective budget. However, budget makers should carefully consider several conditions during the proposal stage.
Top Management Support
All management levels must be aware of the budget's importance to the company and must know that the budget has top management's support. Top management, then, must clearly state long-range goals and broad objectives. These goals and objectives must be communicated throughout the organization. Long-range goals include the expected quality of products or services, growth rates in sales and earnings, and percentage-of-market targets. Overemphasis on the mechanics of the budgeting process should be avoided.
Participation in Goal Setting
Management uses budgets to show how it intends to acquire and use resources to achieve the company's long-range goals. Employees are more likely to strive toward organizational goals if they participate in setting them and in preparing budgets. Often, employees have significant information that could help in preparing a meaningful budget. Also, employees may be motivated to perform their own functions within budget constraints if they are committed to achieving organizational goals.
Although many companies have used participatory budgeting successfully, it does not always work. Studies have shown that in many organizations, participation in the budget formulation failed to make employees more motivated to achieve budgeted goals. Whether or not participation works depends on management's leadership style, the attitudes of employees, and the organization's size and structure. Participation is not the answer to all the problems of budget preparation. However, it is one way to achieve better results in organizations that are receptive to the philosophy of participation.
Communicating Results
Managers should effectively and promptly communicate results so employees can make any necessary adjustments to their performance. Effective communication implies
- timeliness,
- reasonable accuracy,
- and improved understanding.
Flexibility
If significant basic assumptions underlying the budget change during the year, the planned operating budget should be restated. For control purposes, after the actual level of operations is known, the actual revenues and expenses can be compared to expected performance at that level of operations.
Follow-up
Budget follow-up and data feedback are part of the control aspect of budgetary control. Since budgets are dealing with projections and estimates for future operating results and financial positions, managers must continuously check their budgets and correct them if necessary. Often management uses performance reports as a follow-up tool to compare actual results with budgeted results.
Attributions
"Accounting Principles: A Business Perspective" by Roger H. Hermanson, PhD, CPA; James Don Edwards PhD, D.H.C, CPA; Michael W. Maher PhD, CPA, Global Text Project, Open Education Network is licensed under CC BY 3.0
Analyzing Financial Statements
Learning Objectives
4f Analyze financial statements.
4h Discuss the importance of ROIC.
Financial Statement Analysis
Financial statement analysis reviews financial information found on financial statements to make informed decisions about the business. The income statement, statement of retained earnings, balance sheet, and statement of cash flows, among other financial information, can be analyzed. The information obtained from this analysis can benefit decision-making for internal and external stakeholders and can give a company valuable information on overall performance and specific areas for improvement. The analysis can help them with budgeting, deciding where to cut costs, how to increase revenues, and future capital investments opportunities.
When considering the outcomes from analysis, it is important for a company to understand that data produced needs to be compared to others within industry and close competitors. The company should also consider their past experience and how it corresponds to current and future performance expectations. Three common analysis tools are used for decision-making; horizontal analysis, vertical analysis, and financial ratios.
For our discussion of financial statement analysis, we will use Banyan Goods. Banyan Goods is a merchandising company that sells a variety of products. The image below shows the comparative income statements and balance sheets for the past two years.
Keep in mind that the comparative income statements and balance sheets for Banyan Goods are simplified for our calculations and do not fully represent all the accounts a company could maintain. Let’s begin our analysis discussion by looking at horizontal analysis.
Horizontal Analysis
Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items. A company will look at one period (usually a year) and compare it to another period. For example, a company may compare sales from their current year to sales from the prior year. The trending of items on these financial statements can give a company valuable information on overall performance and specific areas for improvement. It is most valuable to do horizontal analysis for information over multiple periods to see how change is occurring for each line item. If multiple periods are not used, it can be difficult to identify a trend. The year being used for comparison purposes is called the base year (usually the prior period). The year of comparison for horizontal analysis is analyzed for dollar and percent changes against the base year.
The dollar change is found by taking the dollar amount in the base year and subtracting that from the year of analysis.
Using Banyan Goods as our example, if Banyan wanted to compare net sales in the current year (year of analysis) of $120,000 to the prior year (base year) of $100,000, the dollar change would be as follows:
The percentage change is found by taking the dollar change, dividing by the base year amount, and then multiplying by 100.
Let’s compute the percentage change for Banyan Goods’ net sales.
This means Banyan Goods saw an increase of $20,000 in net sales in the current year as compared to the prior year, which was a 20% increase. The same dollar change and percentage change calculations would be used for the income statement line items as well as the balance sheet line items. The image below shows the complete horizontal analysis of the income statement and balance sheet for Banyan Goods.
Depending on their expectations, Banyan Goods could make decisions to alter operations to produce expected outcomes. For example, Banyan saw a 50% accounts receivable increase from the prior year to the current year. If they were only expecting a 20% increase, they may need to explore this line item further to determine what caused this difference and how to correct it going forward. It could possibly be that they are extending credit more readily than anticipated or not collecting as rapidly on outstanding accounts receivable. The company will need to further examine this difference before deciding on a course of action. Another method of analysis Banyan might consider before making a decision is vertical analysis.
Vertical Analysis
Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement. For example, a company may compare cash to total assets in the current year. This allows a company to see what percentage of cash (the comparison line item) makes up total assets (the other line item) during the period. This is different from horizontal analysis, which compares across years. Vertical analysis compares line items within a statement in the current year. This can help a business to know how much of one item is contributing to overall operations. For example, a company may want to know how much inventory contributes to total assets. They can then use this information to make business decisions such as preparing the budget, cutting costs, increasing revenues, or capital investments.
The company will need to determine which line item they are comparing all items to within that statement and then calculate the percentage makeup. These percentages are considered common-size because they make businesses within industry comparable by taking out fluctuations for size. It is typical for an income statement to use net sales (or sales) as the comparison line item. This means net sales will be set at 100% and all other line items within the income statement will represent a percentage of net sales.
On the balance sheet, a company will typically look at two areas: (1) total assets, and (2) total liabilities and stockholders’ equity. Total assets will be set at 100% and all assets will represent a percentage of total assets. Total liabilities and stockholders’ equity will also be set at 100% and all line items within liabilities and equity will be represented as a percentage of total liabilities and stockholders’ equity. The line item set at 100% is considered the base amount and the comparison line item is considered the comparison amount. The formula to determine the common-size percentage is:
For example, if Banyan Goods set total assets as the base amount and wanted to see what percentage of total assets were made up of cash in the current year, the following calculation would occur.
Cash in the current year is $110,000 and total assets equal $250,000, giving a common-size percentage of 44%. If the company had an expected cash balance of 40% of total assets, they would be exceeding expectations. This may not be enough of a difference to make a change, but if they notice this deviates from industry standards, they may need to make adjustments, such as reducing the amount of cash on hand to reinvest in the business. The image below shows the common-size calculations on the comparative income statements and comparative balance sheets for Banyan Goods.
Even though vertical analysis is a statement comparison within the same year, Banyan can use information from the prior year’s vertical analysis to make sure the business is operating as expected. For example, unearned revenues increased from the prior year to the current year and made up a larger portion of total liabilities and stockholders’ equity. This could be due to many factors, and Banyan Goods will need to examine this further to see why this change has occurred. Let’s turn to financial statement analysis using financial ratios.
Overview of Financial Ratios
Financial ratios help both internal and external users of information make informed decisions about a company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal operations, among other things, based in part on the outcomes of ratio analysis. The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors. There are four main categories of ratios: liquidity, solvency, efficiency, and profitability. Note that while there are more ideal outcomes for some ratios, the industry in which the business operates can change the influence each of these outcomes has over stakeholder decisions. (You will learn more about ratios, industry standards, and ratio interpretation in advanced accounting courses.)
Liquidity Ratios
Liquidity ratios show the ability of the company to pay short-term obligations if they came due immediately with assets that can be quickly converted to cash. This is done by comparing current assets to current liabilities. Lenders, for example, may consider the outcomes of liquidity ratios when deciding whether to extend a loan to a company. A company would like to be liquid enough to manage any currently due obligations but not too liquid where they may not be effectively investing in growth opportunities. Three common liquidity measurements are working capital, current ratio, and quick ratio.
Working Capital
Working capital measures the financial health of an organization in the short-term by finding the difference between current assets and current liabilities. A company will need enough current assets to cover current liabilities; otherwise, they may not be able to continue operations in the future. Before a lender extends credit, they will review the working capital of the company to see if the company can meet their obligations. A larger difference signals that a company can cover their short-term debts and a lender may be more willing to extend the loan. On the other hand, too large of a difference may indicate that the company may not be correctly using their assets to grow the business. The formula for working capital is:
Using Banyan Goods, working capital is computed as follows for the current year:
In this case, current assets were $200,000, and current liabilities were $100,000. Current assets were far greater than current liabilities for Banyan Goods and they would easily be able to cover short-term debt.
The dollar value of the difference for working capital is limited given company size and scope. It is most useful to convert this information to a ratio to determine the company’s current financial health. This ratio is the current ratio.
Current Ratio
Working capital expressed as a ratio is the current ratio. The current ratio considers the amount of current assets available to cover current liabilities. The higher the current ratio, the more likely the company can cover its short-term debt. The formula for current ratio is:
The current ratio in the current year for Banyan Goods is:
A 2:1 ratio means the company has twice as many current assets as current liabilities; typically, this would be plenty to cover obligations. This may be an acceptable ratio for Banyan Goods, but if it is too high, they may want to consider using those assets in a different way to grow the company.
Quick Ratio
The quick ratio, also known as the acid-test ratio, is similar to the current ratio except current assets are more narrowly defined as the most liquid assets, which exclude inventory and prepaid expenses. The conversion of inventory and prepaid expenses to cash can sometimes take more time than the liquidation of other current assets. A company will want to know what they have on hand and can use quickly if an immediate obligation is due. The formula for the quick ratio is:
The quick ratio for Banyan Goods in the current year is:
A 1.6:1 ratio means the company has enough quick assets to cover current liabilities.
Another category of financial measurement uses solvency ratios.
Solvency Ratios
Solvency implies that a company can meet its long-term obligations and will likely stay in business in the future. To stay in business the company must generate more revenue than debt in the long-term. Meeting long-term obligations includes the ability to pay any interest incurred on long-term debt. Two main solvency ratios are the debt-to-equity ratio and the times interest earned ratio.
Debt to Equity Ratio
The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing. A company can take out loans, issue stock, and retain earnings to be used in future periods to keep operations running. It is less risky and less costly to use equity sources for financing as compared to debt resources. This is mainly due to interest expense repayment that a loan carries as opposed to equity, which does not have this requirement. Therefore, a company wants to know how much debt and equity contribute to its financing. Ideally, a company would prefer more equity than debt financing. The formula for the debt to equity ratio is:
The information needed to compute the debt-to-equity ratio for Banyan Goods in the current year can be found on the balance sheet.
This means that for every $1 of equity contributed toward financing, $1.50 is contributed from lenders. This would be a concern for Banyan Goods. This could be a red flag for potential investors that the company could be trending toward insolvency. Banyan Goods might want to get the ratio below 1:1 to improve their long-term business viability.
Times Interest Earned Ratio
Time interest earned measures the company’s ability to pay interest expense on long-term debt incurred. This ability to pay is determined by the available earnings before interest and taxes (EBIT) are deducted. These earnings are considered the operating income. Lenders will pay attention to this ratio before extending credit. The more times over a company can cover interest, the more likely a lender will extend long-term credit. The formula for times interest earned is:
The information needed to compute times interest earned for Banyan Goods in the current year can be found on the income statement.
The $43,000 is the operating income, representing earnings before interest and taxes. The 21.5 times outcome suggests that Banyan Goods can easily repay interest on an outstanding loan and creditors would have little risk that Banyan Goods would be unable to pay.
Another category of financial measurement uses efficiency ratios.
Efficiency Ratios
Efficiency shows how well a company uses and manages their assets. Areas of importance with efficiency are management of sales, accounts receivable, and inventory. A company that is efficient typically will be able to generate revenues quickly using the assets it acquires. Let’s examine four efficiency ratios: accounts receivable turnover, total asset turnover, inventory turnover, and days’ sales in inventory.
Accounts Receivable Turnover
Accounts receivable turnover measures how many times in a period (usually a year) a company will collect cash from accounts receivable. A higher number of times could mean cash is collected more quickly and that credit customers are of high quality. A higher number is usually preferable because the cash collected can be reinvested in the business at a quicker rate. A lower number of times could mean cash is collected slowly on these accounts and customers may not be properly qualified to accept the debt. The formula for accounts receivable turnover is:
Many companies do not split credit and cash sales, in which case net sales would be used to compute accounts receivable turnover. Average accounts receivable is found by dividing the sum of beginning and ending accounts receivable balances found on the balance sheet. The beginning accounts receivable balance in the current year is taken from the ending accounts receivable balance in the prior year.
When computing the accounts receivable turnover for Banyan Goods, let’s assume net credit sales make up $100,000 of the $120,000 of the net sales found on the income statement in the current year.
An accounts receivable turnover of four times per year may be low for Banyan Goods. Given this outcome, they may want to consider stricter credit lending practices to make sure credit customers are of a higher quality. They may also need to be more aggressive with collecting any outstanding accounts.
Total Asset Turnover
Total asset turnover measures the ability of a company to use their assets to generate revenues. A company would like to use as few assets as possible to generate the most net sales. Therefore, a higher total asset turnover means the company is using their assets very efficiently to produce net sales. The formula for total asset turnover is:
Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year.
Banyan Goods’ total asset turnover is:
The outcome of 0.53 means that for every $1 of assets, $0.53 of net sales are generated. Over time, Banyan Goods would like to see this turnover ratio increase.
Inventory Turnover
Inventory turnover measures how many times during the year a company has sold and replaced inventory. This can tell a company how well inventory is managed. A higher ratio is preferable; however, an extremely high turnover may mean that the company does not have enough inventory available to meet demand. A low turnover may mean the company has too much supply of inventory on hand. The formula for inventory turnover is:
Cost of goods sold for the current year is found on the income statement. Average inventory is found by dividing the sum of beginning and ending inventory balances found on the balance sheet. The beginning inventory balance in the current year is taken from the ending inventory balance in the prior year.
Banyan Goods’ inventory turnover is:
1.6 times is a very low turnover rate for Banyan Goods. This may mean the company is maintaining too high an inventory supply to meet a low demand from customers. They may want to decrease their on-hand inventory to free up more liquid assets to use in other ways.
Days’ Sales in Inventory
Days’ sales in inventory expresses the number of days it takes a company to turn inventory into sales. This assumes that no new purchase of inventory occurred within that time period. The fewer the number of days, the more quickly the company can sell its inventory. The higher the number of days, the longer it takes to sell its inventory. The formula for days’ sales in inventory is:
Banyan Goods’ days’ sales in inventory is:
243 days is a long time to sell inventory. While industry dictates what is an acceptable number of days to sell inventory, 243 days is unsustainable long-term. Banyan Goods will need to better manage their inventory and sales strategies to move inventory more quickly.
The last category of financial measurement examines profitability ratios.
Profitability Ratios
Profitability considers how well a company produces returns given their operational performance. The company needs to leverage its operations to increase profit. To assist with profit goal attainment, company revenues need to outweigh expenses. Let’s consider three profitability measurements and ratios: profit margin, return on total assets, and return on equity.
Profit Margin
Profit margin represents how much of sales revenue has translated into income. This ratio shows how much of each $1 of sales is returned as profit. The larger the ratio figure (the closer it gets to 1), the more of each sales dollar is returned as profit. The portion of the sales dollar not returned as profit goes toward expenses. The formula for profit margin is:
For Banyan Goods, the profit margin in the current year is:
This means that for every dollar of sales, $0.29 returns as profit. If Banyan Goods thinks this is too low, the company would try and find ways to reduce expenses and increase sales.
Return on Total Assets
The return on total assets measures the company’s ability to use its assets successfully to generate a profit. The higher the return (ratio outcome), the more profit is created from asset use. Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year. The formula for return on total assets is:
For Banyan Goods, the return on total assets for the current year is:
The higher the figure, the better the company is using its assets to create a profit.
Industry standards can dictate what is an acceptable return.
Return on Equity
Return on equity measures the company’s ability to use its invested capital to generate income. The invested capital comes from stockholders investments in the company’s stock and its retained earnings and is leveraged to create profit. The higher the return, the better the company is doing at using its investments to yield a profit. The formula for return on equity is:
Average stockholders’ equity is found by dividing the sum of beginning and ending stockholders’ equity balances found on the balance sheet. The beginning stockholders’ equity balance in the current year is taken from the ending stockholders’ equity balance in the prior year. Keep in mind that the net income is calculated after preferred dividends have been paid.
For Banyan Goods, we will use the net income figure and assume no preferred dividends have been paid. The return on equity for the current year is:
The higher the figure, the better the company is using its investments to create a profit.
Industry standards can dictate what is an acceptable return.
Return on Capital or Return on Invested Capital
ROC or ROIC is a ratio used as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits.
The ratio is calculated by dividing the after tax operating income (NOPAT) by the average book-value of the invested capital (IC).
While ratios such as return on equity and return on assets use net income as the numerator, ROIC uses net operating income after tax (NOPAT), which means that after-tax expenses (income) from financing activities are added back to (deducted from) net income.
While many financial computations use market value instead of book value (for instance, calculating debt-to-equity ratios or calculating the weights for the weighted average cost of capital (WACC)), ROIC uses book values of the invested capital as the denominator. This procedure is done because, unlike market values which reflect future expectations in efficient markets, book values more closely reflect the amount of initial capital invested to generate a return.
The denominator represents the average value of the invested capital rather than the value of the end of the year. This is because the NOPAT represents a sum of money flows, while the value of the invested capital changes every day (e.g., the invested capital on December 31 could be 30% lower than the invested capital on December 30).
Advantages and Disadvantages of Financial Statement Analysis
There are several advantages and disadvantages to financial statement analysis.
Financial statement analysis can show trends over time, which can be helpful in making future business decisions. Converting information to percentages or ratios eliminates some of the disparity between competitor sizes and operating abilities, making it easier for stakeholders to make informed decisions. It can assist with understanding the makeup of current operations within the business, and which shifts need to occur internally to increase productivity.
A stakeholder needs to keep in mind that past performance does not always dictate future performance. Attention must be given to possible economic influences that could skew the numbers being analyzed, such as inflation or a recession. Additionally, the way a company reports information within accounts may change over time. For example, where and when certain transactions are recorded may shift, which may not be readily evident in the financial statements.
A company that wants to budget properly, control costs, increase revenues, and make long-term expenditure decisions may want to use financial statement analysis to guide future operations. As long as the company understands the limitations of the information provided, financial statement analysis is a good tool to predict growth and company financial strength.
Attributions
"Principles of Accounting, Volume 1: Financial Accounting" by Mitchell Franklin, Patty Graybeal, Dixon Cooper, OpenStax is licensed under CC BY-NC-SA 4.0
Access for free at https://openstax.org/books/principles-financial-accounting/pages/a-financial-statement-analysis
"Return on capital" by Wikipedia is licensed under CC BY-SA 3.0
Insert
Budgets and their Use in Agribusiness
Excerpt used with permission from "Budgets: Their Use in Farm Management" by Roger Sahs, Courtney Bir, Oklahoma State University Extension. Copyright © OSU Extension.
Learning Objectives
4c Understand Operating, Cash Flow, and Capital Expenses Budgets, that components of each budget type and how each budget is utilized in agribusiness.
4f Analyze financial statements.
How to Best Organize and Manage the Farm
Questions of how to best organize and manage the farm business in a manner consistent with the goals and objectives of the farm family must be continually addressed. The decision as to whether the considered alternatives are consistent with established goals and objectives rests upon the farmer and the farm family acting as the manager if no outside management is hired. Budgeting is a management tool that can provide information to answer a multitude of questions if used properly. Combining inputs into products, allocating resources to alternative products and choosing combinations of different products can be analyzed efficiently through the use of budgets.
The purpose of this OSU Extension Fact Sheet is to describe the different types of budgets available to farm managers. Several basic economic principles will be introduced that relate to the budgeting process.
Introduction
The agricultural producer or farm manager is faced with organizing and managing farm resources to maxi-mize economic returns to owned or controlled resources. Resources include land (owned and rented) and associated improvements, capital assets such as machinery and breeding livestock (borrowed and owned) and labor (hired, farm operator and additional family). The manager is responsible for combining available resources and knowledge to best achieve the desired goals and objectives of the farm business.
With budgets, management can begin to answer such questions as:
- How may the available resources best be used?
- What enterprises (crops and/or livestock) can be produced and which will contribute most to returns to owned resources?
- How much of the controlled land should be devoted to each enterprise?
- What equipment and machinery will be needed to produce the potential enterprises?
- What production practices should be used to produce each of the enterprises?
- How much labor (both family and hired) will be needed on the farm?
- What are the capital requirements?
- Farm management skills and knowledge are an integral part of financial success.
Resource Allocation
- The problems of resource use and allocation involve the application of five economic principles. These principles, in a simplified form, consist of:
- Adding units of an input as long as the value of the resulting output or added returns is greater than the added cost.
- Substituting one input for another as long as the cost of the added input is less than the cost of the input that is replaced and the output is maintained.
- Substituting one product for another as long as the value of the added output is greater than the value of the output that is replaced and the cost is constant.
- Using each unit of resource where it gives the greatest returns when resources are limited.
- Basing comparisons upon discounted values when considering different time periods and/or elements of risk.
- The first three principles relate to situations where unlimited resources are available for use by the manager with perfect knowledge. The last two relate to situations where there are limited resources and when there is not perfect knowledge.
Most resource allocation management problems faced by farm managers can be addressed by applying the basic budgeting economic principles. Numerical calculations to assist in making management decisions. No one type of budget is tied to any particular principle. The type of budget relates to the intent of the analysis, while the principles relate to the farm resources and the resource relationships that exist.
Types of Budgets
There are three basic types of budgets that can be used in the farm business management process. Each type of budget provides different information to the manager for use in the decision-making process. The common thread in each type is that, if properly defined and used, the budget format permits the manager to use economic logic to answer questions of what, how much and when resources should be used to achieve the goals and objectives as established by the farm family.
The three types of budgets are:
- Whole-farm budget
- Enterprise budget
- Partial budget
The whole-farm budget is a classified and detailed summary of the major physical and financial features of the entire farm business. Whole-farm budgets identify the component parts of the total farm business and determine the relationships among the different parts, both individually and as a whole.
An enterprise budget is a statement of what generally is expected from a set of particular production practices when producing a specified amount of product. It consists of a statement of revenues from and the expenses incurred in the production of a particular product. An enterprise budget documents variable and fixed costs. It is useful in calculating profitability and break-even values.
The partial budget is useful in analyzing the effects of a change from an existing plan. This budget only considers revenue and expense items that will change with a defined change in the plan.
Whole-Farm Budget
To develop a whole-farm budget:
- List the goals and objectives of the farm firm.
- Inventory the resources available for use in production.
- Determine physical production data that will be used in the input/output process.
- Identify reliable input and output prices.
- Calculate the expected variable and fixed costs and all returns.
Since it is a plan for the future use of farm resources and establishes the future direction of the farm organization, the whole-farm budget must conform to the farm family goals and objectives to be successful. Farm management that is goal-directed integrates the goals and objectives of the farm with those of the family and reduces pressure on competitive uses of family controlled resources. OSU Extension fact sheet AGEC-244, “Goal Setting for Farm and Ranch Families,” can help develop a process for identifying farm and family goals, prioritizing them, and identifying management strategies that will achieve the identified goals (a worksheet is included). The whole-farm budget is the best tool to analyze the farm business and the impacts of the goals and objectives.
The whole-farm budget should start with the inputs the operator has available for use in the farm business. Often the amount of land and operating capital available are limiting factors. Other factors such as buildings, the farmer’s manage-rial skills and available markets can also be relatively fixed. It is important to start with those fixed elements in planning a whole-farm budget. The results of the whole-farm budget should combine the resources, constraints, technical information and price data into a realistic whole-farm budget for the farm being considered. The outcome should be a plan that can provide direction for the farmer and family to follow in maximizing the returns to owned resources.
An Enterprise Budget
Although managers lack information needed to make perfect decisions, they are forced to make decisions using information available, then must accept the risk associated with that decision. An enterprise budget provides a format for the manager to use in classifying information so the economics of alternative enterprises and alternative production systems can be consistently analyzed.
One problem in enterprise budgeting is the lack of information concerning the amount of products that will result from particular combinations of inputs for example, how much forage would be produced with a certain amount of seed and fertilizer. Seldom do managers have certainty regarding technical production information as producers never have complete information with regard to production conditions, such as weather and insects. Typically, more information is available regarding the prices of inputs than on products since inputs are purchased during one time period and products are sold in a later time period. The greater lag between planning and actual use of information on product prices relative to input prices adds uncertainty and product price risk that must be considered when planning.
An enterprise budget should contain several components. A detailed description should include a production goal, the production techniques to be employed, the land resource required and even something about the capital and labor requirements. An enterprise budget should include all costs and all returns associated with the defined enterprise. All variable and fixed costs, both cash and non-cash items, should be included. The returns from products produced for sale (wheat grain crop) plus those produced for use in another enterprise (grazing) should be included in an enterprise budget.
Variable costs are the costs of such input items as seed, feed, fertilizer, normal repairs, custom operations and machinery and equipment operating expenses. These costs also include labor, whether associated with machinery or equipment or as hand labor operations. They are items that will be used during one year’s operation or during one production period and would not be purchased if the enterprise was not produced. Variable costs are always included in an enterprise budget.
Fixed costs are the costs associated with buildings, machinery, and equipment which are prorated over a period of years. Included in this category are depreciation, interest, insurance, and taxes on individual buildings and pieces of machinery and equipment that can be allocated to an individual enterprise. Fixed costs are always included in an enterprise budget.
Some costs of production are difficult to allocate to a specific enterprise. The costs are generally classified as overhead costs and include costs usually associated with buildings, utilities and other miscellaneous items (such as recordkeeping and budgeting) that are used in more than one enterprise and are not easily allocated to an individual enterprise. Overhead costs can include both variable and fixed costs. It is necessary to allocate all costs of producing an enterprise even if an arbitrary method of allocation must be used. The key to allocating costs is to develop a process that is consistent over time.
The OSU Agricultural Economics Department has developed software tools to assist producers in analyzing many Oklahoma crop and livestock enterprises. Information and sample reports are available at Enterprise Budgets Home.
The Partial Budget Concept
Partial budgeting is a procedure where receipts and expenses which increase/decrease with a change in organization or procedures are listed in a systematic order. It is a process to allow a total farm budget to be fine-tuned. It focuses the analysis of a defined change to see if it improves the total farm budget.
The steps in constructing a partial budget are to:
- State the proposed alternative or change that will be analyzed.
- Collect data on all aspects of the business that will be affected by the change.
- Classify or group the types of impacts that will occur by including expenses increased or reduced and receipts increased or reduced.
- The partial budget (example in Table 1) is based on the concept that a change in the organization of the business will have one or more of the following effects:
Partial Budget, Wheat Grazeout versus Harvest for Grain
Situation: Should I leave stockers on wheat pasture for 60 days rather than remove stockers and combine wheat?
Additional Costs |
|
|
| Interest on Investment | $10.00 |
| Additional vet/feed/etc | $3.00 |
Reduced Returns |
|
|
| Steers: 640 lbs x $1.52/lb | $972.80 |
| Wheat Sales: 35 bushel x 4.50/bushel | $157.50 |
Total Annual Additional Costs and Reduced Returns |
| $1,143.30 (A) |
Additional Returns |
|
|
| Steers: 790lbs x $1.35/lb | $1066.50 |
Reduced Costs |
|
|
| Harvesting $24/acre + ($0.24/bushel x14) | $27.36 |
| Hauling $0.22 x 35 bushel/acre | $7.70 |
Total Annual Additional Costs and Reduced Returns |
| $1,101.56 (B) |
Net Change in Income (B – A) $1,101.56 - $1,143.30 = -41.74
1Estimates are based on a stocking rate of one head per acre.
Positive Economic Effects
- The change will eliminate or reduce some costs.
- The change will increase returns.
Negative Economic Effects
- The change will cause some additional costs.
- The change will eliminate or reduce some returns.
- The net change between positive and negative economic effects is an estimate of the net effect of making the proposed change in the total farm budget.
- A positive net change indicates a potential increase in income and a negative net change indicates a potential reduction in income due to the proposed change.
In the example, the total of the Additional Returns/Reduced Costs column is $1,101.56 and the total of the Additional Costs/Reduced Returns is $1,143.30. Subtracting the total of column A from B yields a net value of -$41.74 per acre. This represents the amount of economic loss with grazing out the wheat rather than selling the steers on March 1 and combining the wheat. Note that with different prices or stocking rates, the conclusion could be different. In some years, grazing out is the more profitable option so having accurate price forecasts is critical.
Sources of Budget Information
All budgets should be based upon the best information available. The reliability of the budgets is only as good as the quality of the data used in the process. Data needed for use in budgets includes quantity, price, method and timing of the inputs used.
Some sources of information available for use in preparing budgets are:
- Actual farm records
- Area summary analysis
- County production data
- Typical budgets
- Farm literature
- Information from meetings
- Neighbors
Any or all of these sources should be used in collecting and verifying data or information used in preparing budgets. Good managers verify the reliability of data collected from any source to see that it applies to their situation. Experience from one year is only an indicator and does not assure that same response will result in following years.
Budget Limitations
Careful evaluation of the resource situation must precede the drawing of inferences from budgets. Farms with different owned resource situations can have different management plans given the same basic budget information. Budget data for a 160-acre farm can be used in preparing a budget for a farm of 320 acres; however, differences in resources and organization must be considered and adequately accounted for if the end result is to be reliable and useful.
Budgets are generally constructed to reflect future actions and it is difficult to accurately predict future prices and yields. Historical data provide some basis for establishing initial levels of budget yield, price and timing data. Several options are available in establishing future prices such as forward contracting and hedging techniques.
Production and marketing risks will limit budget reliability. Best estimates should be used to develop budgets for use in farm business analysis. However, high degrees of variability create risk to the operator and put pressure on the reliability of the estimates used in the enterprise budgets. One alternative is to evaluate best- and worst-case scenarios in addition to the expected outcome. Probability distributions on weather events and prices can add valuable insights. Even with careful use, errors can compound themselves to the point where budgets can have little or no value. This element of risk should be considered and evaluated by the manager when determining the solutions that best meet the goals and objectives of the farm family.
Budget preparation is time consuming. It requires pencil and calculator activity as well as searching data sources for information to be used in preparing the budget. Software also is available to assist in budget calculations. As with all problems, this becomes an economic question such that the farmer faces the problem of allocating their time in a manner whereby the returns from budgeting are greater than the cost of gathering the information.
Why Budget?
Using budgets can provide the farm manager a method to:
Experiment through simulation with possible outcomes of a given organizational change before resources are actually committed to the change.
- Uncover cost items that might otherwise be overlooked.
- Refine the present organization.
- Seek credit from lending agencies.
- Learn to better organize and reorganize.
Aids to the Process
The Department of Agricultural Economics has decision aids and materials available to assist farmers in building an information system, using information to develop all types of budgets and using budgets in management decisions. Meetings are held upon request throughout Oklahoma to provide the most current information available. Computer software has been developed to assist with the analysis and assimilation of data into the management framework.
Enterprise budgets developed by the Department of Agricultural Economics are available at Enterprise Budgets Home. Those interested in obtaining enterprise budgets may also contact their Extension Educators — Agriculture, Area Agricultural Economics Specialist, or State Agricultural Economics Specialist, Room 515, Agricultural Hall, OSU, Stillwater, OK 74078, (405) 744-9836 for more information.
Record keeping systems (both manual and electronic) as explained in OSU Extension Fact Sheet AGEC-302, “Information Systems for Oklahoma Farmers,” are available to help organize historical data for use in business management. One such affordable software program that is appropriate for farms and ranches requiring only cash records is Quicken. More information on using Quicken for farm financial record keeping is available from the OSU Department of Agricultural Economics at About Quicken. For smaller or less complex businesses, hand-kept ledgers may still be a satisfactory alternative. The Oklahoma Farm and Ranch Account Book is designed to be a comprehensive, easy to use, manual record-keeping system. A customized book can be built and printed for individual needs at OSU Farmbook. Other types of ledgers are often available from agricultural lenders, farm supply dealers, and farm management firms.
Summary
Budgets (whole-farm, enterprise, and partial) are management tools to help evaluate the farm business. Each type of budget has a different but related purpose and should be used by managers accordingly. The whole-farm budget becomes a starting point that can be used to analyze the farm business over time. Enterprise budgets can be used to analyze components of the farm business and also be a building block for the whole-farm. Once a whole-farm budget has been developed, a partial budget can be valuable in evaluating changes to the total-farm budget. Each type of budget offers useful information to support management decisions.
Attributions
"Budgets: Their Use in Farm Management" by Roger Sahs, Courtney Bir, OSU Extension . Copyright © OSU Extension. Used with permission.
Cash Flow Budgeting in Agribusiness
Excerpt used with permission from "Twelve Steps to Cash Flow Budgeting" by William Edwards, Iowa State University Extension and Outreach. Copyright © ISU Extension and Outreach.
Learning Objectives
4c Understand Operating, Cash Flow, and Capital Expenses Budgets, that components of each budget type and how each budget is utilized in agribusiness.
4f Analyze financial statements.
Twelve Steps to Cash Flow Budgeting
How much financing will your farm business require this year? When will money be needed and from where will it come? A little advance planning can help avoid short-term shortages of cash. One useful tool for planning the use of capital in the farm business is a cash flow budget.
A cash flow budget is an estimate of all cash receipts and all cash expenditures that are expected to occur during a certain time period. Estimates can be made monthly, bimonthly, or quarterly, and can include nonfarm income and expenditures as well as farm items. Cash flow budgeting looks only at money movement, though, not at net income or profitability.
A cash flow budget is a useful management tool because it:
- forces you to think through your farming plans for the year.
- tests your farming plans, such as if you will produce enough income to meet all your cash needs.
- projects how much operating credit you will need and when projects when loans can be repaid.
- provides a guide against which you can compare your actual cash flows.
- helps you communicate your farming plans and credit needs to your lender.
Getting Started on the Budget
Developing a cash flow budget for the first time will not be easy. Following a step-by-step approach can make the task less difficult, though. The pages at the end of this publication contain a format for completing your plan, although other forms can be used. There also are many personal computer programs available for developing cash flow budgets. Or, you may want to develop your own. In any case, the following steps can be applied.
1. Outline your tentative plans for livestock and crop production for the year, as shown in Example 1.
2. Take an inventory of livestock on hand and crops in storage now. If a recent financial statement is available, information found under the current assets section can be used.
3. Estimate feed requirements for the proposed livestock program, as shown in Example 2. Some typical feed requirements are contained in ISU Extension publication FM 1815/AgDM B1-21, Livestock Enterprise Budgets for Iowa. Your own past feed records are also a good guide.
Adjust feed requirements if livestock will complete only part of the feeding program during the budget year. It also is helpful to divide requirements for homegrown feedstuffs between the periods prior to harvest and following harvest.
4. Estimate feed available, as shown in Example 2. List beginning inventories prior to harvest, and expected new crop production after harvest. Remember to exclude grain transferred to the landlord under a cropshare lease. Finally, estimate the quantity of feed purchases needed, if any, and the quantity available to sell. Once your feed supply and feed requirements are estimated, you may want to adjust the livestock program to fit them.
5. Now you are ready to start with the actual cash flow budget.
First estimate livestock sales, based on production and marketing plans, as shown in the top line of Example 3.
Start with livestock on hand, then add livestock to be produced during the year. Exclude animals to be carried over to next year or held back for breeding stock.
- Include sales of breeding stock that will be culled.
- Include livestock product sales, such as for milk or wool.
- Use your best estimate of selling prices based on outlook forecasts or marketing contracts.
- Reflect expected seasonal price patterns when appropriate, rather than using the same price all year.
Stay on the conservative side. If your plan will work at conservative prices, it also will work at better prices.
Some producers prepare budgets at two or three price levels for the major products they sell. This helps them identify the amount of price risk they face.
6. Plan sales of nonfeed crops and excess feed.
- Consider crops in inventory at the beginning of the year as well as crops to be harvested during the year. Plan to carry over grain for feed for next year plus other crops normally sold in the following year.
- Plan timing of sales according to your normal marketing strategy. In Example 3, the farmer plans to sell old-crop soybeans in March and hold new-crop soybeans until after January 1 of next year.
- Follow the same guidelines as in step 5 for estimating crop prices. Look at outlook forecasts, consider seasonal price patterns, and use conservative price estimates.
- Multiply quantities to sell by anticipated prices, and carry the totals to the budget form.
After the initial cash flow budget is completed, you may want to revise your marketing plans to meet capital needs throughout the year.
7. Estimate income from other sources, including:
- USDA farm payments
- custom machine work income
- income from off-farm work, rental property, or other business activities
- interest, dividends, patronage refunds, etc.
Last year’s additional cash income listed on your income tax return is a useful guide.
8. Project crop expenses and other farm operating expenditures.
Last year’s expenditures are a good guide. Adjust for changes in price levels.
If cropping plans will be different this year, detailed field-by-field production plans or field maps can be used to estimate expenses.
Expenses that are determined by contract, agreement, or law can be estimated directly from contract terms, unless rates are expected to change. These include property taxes, property and liability insurance premiums, and fixed cash rents.
Expenses should be spaced through the year based on your best judgment. Some will fall mainly during certain seasons, such as machine hire, part-time labor, and crop expenses.
Remember to place these expenses during the period of payment, not the period of use. Some expenses will be spread through the year but will have definite seasonal peaks. Fuel, machinery and equipment repair, and utilities are examples. Other expenses may be spaced evenly through the year, such as vehicle operating expenses, livestock health and supplies, and purchased feed.
9. Consider capital purchases
such as machinery, equipment, land, or additional breeding livestock. Major machinery expenses such as a tractor overhaul also can be included here, as well as construction or improvement of buildings. Example 3 shows that the farmer is considering trading for a new combine for a cost of $50,000. This amount is entered under the “Purchases of Capital Assets” section. Show only the cash difference to be paid when a trade is involved.
You may want to complete the rest of the cash flow budget first to see if major capital expenditures will be feasible this year. If a portion of the item will be financed by borrowing, then include the anticipated loan amount in the “Financing” section.
10. Summarize debt repayment.
Much of this information can be taken from your most recent net worth statement. Include only those debts that you have already acquired at the beginning of the budgeting period. Calculate the interest that will be due at the time the payment will be made. Remember, the net worth statement may show only interest accrued up to the date of the statement.
11. Estimate nonfarm expenditures.
Adjust last year’s living expenses for changes in family circumstances and inflation. Remember to allow for possible purchases of vehicles, furniture, appliances, or major repairs, and contributions to retirement accounts.
A tax estimate made at the end of the year for tax management is helpful for projecting income tax and Social Security payments to be made for last year’s income. Your estimate can be revised when your actual tax returns have been completed.
12. Sum total cash inflows and total cash outflows.
Add total projected cash inflows for the year and for each period, as shown in the sample budget in Example 3. Add the total inflows for each period to check that they equal the total projected inflows for the year.
Add total projected cash outflows for the year and for each period. Add the total outflows for each period to check that they equal the total projected outflows for the year.
Subtract total cash outflows from total cash inflows to determine the net cash flow for each period. Add the net cash flows for each period to check that they equal the total net cash flow for the year.
If the estimated net cash flows for the entire year and for each period are all positive, you have a feasible cash flow plan. If the net cash flows for some periods are negative, some adjustments may need to be made.
Analyzing Your Budget
In the example, the farm business will have a net cash flow of $16,989 for the year as a whole. The projected cash outflows include:
$36,000 for family living expenses and $23,000 for nonfarm investments.
$61,078 for repayment of borrowed funds plus interest.
$50,000 for trading combines.
$458,720 for operating expenses.
A cash flow budget only indicates whether or not the farm business will produce enough cash income to meet all demands for cash. It does not estimate net income or profit. Remember that net farm income also includes non-cash items such as depreciation and changes in crop and livestock inventories, and that net farm income can be positive even when net cash flow is negative, and vice versa.
Annual Adjustments
The first step in analyzing cash flow is to add cash on hand to net cash flow. If the total projected net cash flow for the year is still negative, some type of annual adjustments must be made. Alternatives include:
Sell more current assets (crops and livestock). Be careful here, though - reducing inventories may solve the cash flow squeeze this year, but could result in even more severe problems next year.
Carry over operating debt to the following year.
Finance capital expenditures with credit, or postpone them until another year. Anticipated borrowing for capital assets can be included in the financing section under cash inflows.
Reduce the size of intermediate and long-term debt payments by lengthening the repayment period or adding a balloon payment at the end.
Convert short-term debt to intermediate or long-term debt by refinancing it as an amortized loan.
Reduce nonfarm expenditures or increase nonfarm income.
Sell intermediate or long-term assets to raise cash.
In the example, financing 50 percent of the $50,000 combine trade with a lender ($25,000) would leave a positive net cash flow for the year of $41,989. The $25,000 would be entered as new borrowing in the period when the purchase was projected (July through August).
Seasonal Adjustments
Even when the yearly net cash flow is positive, sizable deficits can occur in some months. This is due to the seasonal nature of expenses in farming and the tendency to sell large quantities of a product at one time. Some types of enterprises, such as dairy, produce a more constant cash flow than other types.
Shorter term adjustments can be made when projected net cash flow is positive for the whole year but negative for certain months. These include:
Shift the timing of some sales.
Shift the timing of some expenditures.
Increase short-term borrowing in periods with negative cash flow, and project repayment in periods with positive cash flow. Remember to add interest charges to payments.
Delay the due date of fixed debt payments to match periods with positive net cash flows.
Operating Loan Transactions
In Example 3, cash on hand at the beginning of the year is $6,146. Enter this in the January-February column, as well. Then work through the remaining periods to determine the amount of additional new borrowing needed in each period.
The farmer in the example wishes to plan for a cash balance of at least $1,000 at the end of each period. The cash flow can be balanced by planning to borrow $20,000 in operating capital in January, $5,000 in April, $11,000 in June and $22,000 in October. The operating loan balance ($60,000) can be repaid in December, however, plus interest.
Some farmers operate with a line of credit from their lender, with a maximum borrowing limit, instead of borrowing funds in fixed amounts. The cash flow budget also can be used to test if the need for operating capital will exceed this limit, as shown in the lower part of Example 3.
Add the outstanding balance on the line of credit at the beginning of each period to the amount of new borrowing in that period. If operating debt will be repaid instead, subtract the amount to be repaid to arrive at the ending credit balance for that period. Do not include new borrowing to be repaid over several years (such as for the combine) if the borrowing limit applies only to short-term capital.
In this case we are concerned only with the amount of principal borrowed and repaid, not interest.
In the example, the farmer started the year with an annual operating loan balance of $203,200. The loan balance was projected to drop to $201,200 by the end of the year.
If the projected ending credit balance for any period exceeds the credit limit, adjustments to cash flow can be made as discussed above.
Monitoring Cash Flows
Review your cash flow budget from time to time during the year. Prices and costs may differ from your estimates, or production plans may change. Monthly bank statements and canceled checks are a good source of cash flow information against which your budget can be compared. This will help you anticipate changes in your needs for cash and credit later in the year. You may even need to prepare a revised budget for the remainder of the year.
Developing a cash flow budget for the first time will not be easy. Close communication with your lender is important. By planning where you are going financially, you can increase your chances of arriving there safely. Cash flow budgeting is an essential part of sound financial management.
Budgeting Major Investments
A cash flow budget also can be very helpful in evaluating major capital investments or changes in the farm business. Examples are purchasing land, building new hog facilities, or expanding a beef cow herd. Often it will be necessary to develop two budgets: one for a business year after the investment or change in the business is complete, and one for the intermediate or transition year (or years).
As an example, a beef cow-calf producer decides to expand the herd by buying heifer calves. The producer should develop a total cash flow budget for the operation as it will be after the expansion is complete. However, the greatest cash flow problem may be in the transition year. The expenses will increase because there will be more cattle in the herd but income will not increase until calves from the new heifers are sold.
Expansion of a livestock enterprise through construction of new facilities can often create cash flow problems in the construction year, even if the facilities are financed with an intermediate or long-term loan. This is especially true if it will take some time to expand the enterprise up to the capacity of the facility. In the meantime, the producer will have to meet the loan payments on the facility, as well as pay for additional labor and feed. A set of cash flow budgets could help select the best alternative in terms of financial feasibility.
Attributions
"Twelve Steps to Cash Flow Budgeting" by William Edwards, Iowa State University Extension and Outreach. Copyright © ISU Extension and Outreach. Used with permission.
Net Worth Statements in Agribusiness
Excerpt used with permission from "Your Net Worth Statement" by William Edwards, Iowa State University Extension and Outreach Copyright © ISU Extension and Outreach.
Learning Objectives
4d Understand the accounting equation and all components.
4e Understand the components and uses of a balance sheet and profit and Loss Statement.
Your Net Worth Statement
Would you like to know more about the current financial situation of your farming operation? A simple listing of the property you own and the debts you owe can provide valuable insights. Such a listing is called a net worth statement, or sometimes a financial statement, or balance sheet.
The net worth statement is based on the relationship:
assets = liabilities + net worth, or
assets - liabilities = net worth
Most farm businesses are made up of a combination of land, livestock, crops, and machinery acquired with debt (liabilities) or contributed by the operator (net worth or owner’s equity). The net worth statement is like a photograph of these assets and liabilities on a given date.
Comparing net worth statements made at the end of each year over several years can help you measure the progress of your farm business. The net worth statement also helps you judge the ability of the farm operation to pay off current debts and take on additional ones.
Developing the Statement
A net worth statement may include only the farm business, or it may include household and personal assets and debts as well. For business analysis purposes, only information pertaining to the farming operation is needed. Information about nonfarm assets and liabilities can be added in a separate section and used for analyzing debt repayment capacity. For a farm partnership, include only items owned or owed by the partnership, not by the partners individually.
Most families create a net worth statement as of December 31 or January 1 because this is the end of their accounting year. However, it is possible to develop a statement at any date and as often as needed. A blank form for completing a net worth statement is available at the end of this publication. If you want to create your own net worth statement, as well as an income statement, cash flow statement and statement of owner equity, use Decision Tool Comprehensive Farm Financial Statements or the blank worksheets available in ISU Extension and Outreach publication FM 1824/AgDM C3-56 Farm Financial Statements.
Valuing Assets
Assets are generally listed on the left-hand side and liabilities on the right-hand side of the statement. Both assets and liabilities are divided into current and fixed items.
Current assets include cash, bank accounts, crops, livestock, and supplies that will normally be sold or used within a year.
List the current balances for all your savings and checking accounts used for farm receipts and expenses. If you obtain your current checking account balance from your bank, remember to subtract the value of any checks that are still outstanding.
The key to correctly listing current assets is to accurately estimate both the number and value of items on hand. ISU Extension and Outreach publication FM 1490/AgDM C1-40, Suggested Closing Inventory Prices is helpful for valuing current assets.
For market livestock, begin with an up-to-date inventory of the number of head and estimated weight for each class of livestock. Value them at current market prices, minus potential marketing and transportation costs. Check with local markets or use local prices available from newspapers, websites, or other sources of marketing information.
- Value young livestock at feeder animal prices.
- Value heavier livestock at their estimated weight times the current slaughter market price.
- Use an average of feeder and market livestock prices for animals at intermediate weights.
For grain and feed, including hay, silage, straw, and supplements:
- Begin with accurate estimates of bushels, tons, bales, etc., on hand.
- Include grain under warehouse receipt at an elevator. Also include grain delivered under a deferred pricing (price later) contract if the price has not yet been established or payment received.
- Value crops at current market price, or their contracted price, minus marketing costs. Check with local markets or use local prices available through newspapers, websites, or other sources.
- Include grain placed under a USDA marketing loan. Value it at the current market price or the loan rate, whichever is higher, because you have the option of repaying the loan at a lower rate if the price is below the loan rate. Include the marketing loan as a current liability.
- Value crops that have been hedged with a futures contract at their current market price, not the futures price. Any gains or losses incurred in the futures market will be reflected in the balance of the hedging account.
- Value commercial feed at its purchase cost.
Other current assets include:
- Supplies on hand, such as seed corn, chemicals, medications, and fuel.
- Prepaid expenses, such as payment made for feed to be delivered in the coming year. Show this as an asset only if you have already paid for it or if you show the obligation to pay for it as a liability.
- Money invested in a future crop such as for fall-applied fertilizer. Growing crops generally should be given a value equal to the costs of production already incurred.
- Hedging accounts used for forward pricing grain, livestock, or production inputs. Obtain a current estimate of net market value of all futures and options accounts on the date of the net worth statements, including realized gains from closed contracts, plus margin money deposited.
- Accounts receivable, such as the payment a customer might owe you for custom combining, government payments to be received for past production, or crop insurance payments earned but not yet received.
Fixed assets are those used in farm production, but not intended to be sold or converted directly into marketable products during the year (except for breeding livestock to be culled).
For breeding and dairy livestock:
- Begin with an accurate count of each species and type of livestock.
- Cows or ewes should be valued according to a conservative dairy or breeding value. For sows that are replaced more rapidly, an estimated slaughter value is suggested.
- Avoid making large year-to-year changes in values placed on breeding stock, which can cause large paper increases or decreases in net worth. Establishing a base value for each class of breeding stock and using it each year is recommended.
For machinery, equipment, and vehicles:
- Your tax depreciation schedule should provide a complete inventory.
- Use the depreciated or remaining value (cost minus total depreciation allowed, including depreciation for the past year), under the cost value column. However, if very rapid tax depreciation methods have been used, such as “expensing,” you may want to start with a value that is closer to fair market value.
- Once a total remaining value has been determined, it can be adjusted in following years by this formula:
Value of machinery (or equipment or vehicles) at the beginning of the year
+ net cost of machinery added (purchases or cash difference paid on a trade)
- the value of machinery sold or junked
- depreciation expense for the year (economic, not income tax values) (10% of undepreciated value is suggested)
= machinery value at the end of the year
(see Example 2). - Use a conservative market value under the market value column, or adjust the previous year’s value for purchases, sales, and depreciation. Use the same depreciation expense value that you show on your net income statement.
Do not include machinery, equipment, or breeding livestock that you are leasing, unless they are shown on your tax depreciation schedule.
For perennial or long-term crops such as alfalfa, orchard crops, or some vegetables, sum up all the costs incurred for establishing the crop and depreciate that amount over its remaining productive life.
Other fixed assets include land, buildings, and other improvements. They often have the largest dollar value of any assets on the net worth statement. On some statements, fixed assets are divided into intermediate and long-term assets.
List the cost basis of farm real estate under the cost value column:
- Your original basis is the price you paid for the farm.
- If you received the property through gift, you retain the giver’s basis.
- If you inherited the property, the basis is the value that was used for valuing the estate.
- Adjust the original basis by adding the cost of improvements made and subtracting the depreciation taken on improvements.
List owned farm real estate at a conservative current value in the market value column.
- List the value of improvements separately from real estate. Use the remaining value for depreciable improvements.
- Reduce market value land prices to allow for broker’s commission and other selling costs that might have to be paid if the farm were sold.
Shares in other farming entities such as a sow cooperative should also be shown under fixed assets, as well as shares in other farm corporations or LLCs.
Personal assets such as family bank accounts, retirement accounts, stocks and bonds, household goods, vehicles, housing or other real estate can be listed separately at the bottom of the assets side of the statement.
Listing Liabilities
Liabilities are generally listed on the right-hand side of the net worth statement and include all debts and loan obligations to pay that the farm business or family has on the date of the statement. Liabilities are usually listed according to the length of time before they become due. You may want to list the creditor’s name and the purpose of each liability, as well as the amount, on a separate page.
Current liabilities are those due within the next 12 months.
- Include debts such as operating notes, feeder livestock notes, or the outstanding balance on a credit line with a bank or other lender.
- Accounts payable, such as an unpaid open account with a feed mill or attorney, should also be shown, as well as unpaid wages, custom charges, and farm income and property taxes due.
- Contractual obligations, such as a cash rent leasing agreement or a machinery operating lease, are generally not shown unless they are past due. However, if they are included in liabilities, the value of the rights that you have as a result of the contract should also be shown as an asset. These are generally given the same value as the liability.
- List principal payments due on fixed liabilities within the next 12 months (see Example 3).
- Calculate the amount of unpaid interest accrued on all liabilities as of the date of the statement. Multiply the outstanding principal of each debt by its respective interest rate, then multiply by the fraction of a year that has passed since the last payment, or since the loan was received if no payments have been made yet (see Example 4).
- Some accountants show the potential income tax that would be due if all current assets were sold as a current liability, under deferred tax liabilities.
Fixed liabilities include debts payable more than one year in the future.
- Loans for breeding stock, machinery, land, or farm improvements usually fall into the fixed category.
- A mortgage or contract on real estate is usually a fixed liability, too.
- Show the unpaid balance minus the principal due in the coming year (it has already been shown as a current liability).
- Some accountants show the potential income and capital gain taxes that would be due if all fixed assets were sold as a fixed liability, under deferred tax liabilities.
Personal liabilities can be shown at the bottom of the liabilities column. These include consumer debts, credit card balances, home mortgages, and medical bills to pay.
Net Worth
The difference between total farm assets and total farm liabilities is the net worth, or equity, at the time the statement is made. It is the current value of your own investment in the farming operation. Adding net worth to total liabilities (which is the share of assets contributed by creditors) gives you a value equal to total assets and serves as a check on your calculations.
The cost value net worth shows the value of your own investment excluding changes in the market values of machinery or real estate, while market value net worth does include these changes.
Farm and personal net worth can be added together to find the total family net worth.
Analyzing the Statement
Once you have completed your net worth statement, take time to look it over and understand what it can tell you. To begin, look at each major liability listed and see if a corresponding item can be found under the asset side. The corresponding item will usually be listed under the same section (current or fixed). If a corresponding asset cannot be found, you may have forgotten to list something. Or the asset originally acquired with borrowed money may have already been sold or used up before paying the corresponding liability. This is a danger sign. It means that you must generate funds to pay this debt elsewhere in the farm business.
Another danger sign is a liability that appears closer to the top of the statement than its corresponding asset. An example is a machinery item bought on a one-year note. It is usually difficult to pay for an asset over a period of time considerably shorter than its useful life.
Sometimes the value of a particular liability is greater than the value of its corresponding asset. This may mean that the debt is not adequately secured, or it may occur simply because rapid depreciation methods have been used.
Financial Ratios
Debt-to-asset ratio (or percent debt) is equal to total liabilities divided by the market value of total assets. It indicates the portion of total capital supplied by creditors. A successful farm business will have a decreasing ratio over time, except in years when major assets such as land are purchased with borrowed capital. A low debt-to-asset ratio usually leads to less year-to-year variability in net farm income, but may also cause net worth to grow more slowly.
A personal debt-to-asset ratio also can be calculated, using total farm and personal asset and liability values.
A current ratio can be calculated by dividing total current assets by total current liabilities. This is a measure of liquidity, or the ability to pay bills and debts as they come due over the next 12 months.
A farm business with good overall risk-bearing ability can still have liquidity problems. This may be caused by a low income year resulting in carryover operating debt, or too rapid investment of cash into intermediate and long-term assets, such as machinery or land.
Many lenders consider a current ratio of 2.0 or greater to show good short-term risk-bearing ability, while a ratio close to 1.0 or lower indicates potential cash flow problems. However, this is affected by the type of farm, volume of production, and financial structure. For example, farms with regular livestock sales, such as dairy, often can withstand lower current ratios than crop farms that have production only late in the year.
Some lenders prefer to look at the difference between current assets and current liabilities rather than their ratio. This difference is called working capital. It indicates the potential cash available for meeting daily operating costs, consumption expenditures, and other items not listed under current liabilities.
In many cases current liabilities will be paid from income generated from sales of farm products that have not yet been produced and do not appear as current assets. A more accurate analysis of repayment capacity can be made by developing a cash flow budget, as explained in ISU Extension and Outreach publication FM 1792/AgDM C3-15 Twelve Steps to Cash Flow Budgeting.
Year-to-year Comparisons
The financial progress of the farm business can be measured by comparing a current net worth statement with earlier ones.
The change in cost value net worth from one year to the next shows the growth (or loss) due to net income earned from the farm business, and consumption. The following formula summarizes the relation among cost value net worth, income, and consumption expenditures:
net farm income (accrual)
+ non-farm income, gifts, or inheritances invested in the farm business
- farm income used for living expenses, income tax payments, and other consumption
= change in cost value farm net worth
The change in market value net worth is found by subtracting the market net worth shown on last year’s financial statement from that shown on this year’s. It measures the change in the market value of your equity share of the farm business. It also depends on net income and consumption, but includes changes in the market value of land or machinery, as well. It can also be expressed as a percent of net worth at the beginning of the year.
A decrease in net worth from one year to the next may result from low net farm income or high consumption expenditures. It may also result from large changes in inventory prices of current and fixed assets. For this reason, it is useful to compare similar items on the balance sheet from one year to the next. Changes in their values may be due to changes in volume, changes in unit prices, or both.
Many different forms and formats exist for developing a net worth statement. However, all of them contain the same basic information. Completing an annual net worth statement is one of the simplest means available for analyzing the risk-bearing ability and financial progress of your farm business.
Year-to-year Comparisons
The financial progress of the farm business can be measured by comparing a current net worth statement with earlier ones.
The change in cost value net worth from one year to the next shows the growth (or loss) due to net income earned from the farm business, and consumption. The following formula summarizes the relation among cost value net worth, income, and consumption expenditures:
net farm income (accrual)
+ non-farm income, gifts, or inheritances invested in the farm business
- farm income used for living expenses, income tax payments, and other consumption
= change in cost value farm net worth
The change in market value net worth is found by subtracting the market net worth shown on last year’s financial statement from that shown on this year’s. It measures the change in the market value of your equity share of the farm business. It also depends on net income and consumption, but includes changes in the market value of land or machinery, as well.
A decrease in net worth from one year to the next may result from low net farm income or high consumption expenditures. It may also result from large changes in inventory prices of current and fixed assets. For this reason, it is useful to compare similar items on the balance sheet from one year to the next. Changes in their values may be due to changes in volume, changes in unit prices, or both.
Many different forms and formats exist for developing a net worth statement. However, all of them contain the same basic information. Completing an annual net worth statement is one of the simplest means available for analyzing the risk-bearing ability and financial progress of your farm business.
Attributions
"Your Net Worth Statement" by William Edwards, Iowa State University Extension and Outreach Copyright © ISU Extension and Outreach. Used with permission.
Important Financial Statements for Agribusiness
Excerpt used with permission from "Your Net Worth Statement" and "Your Farm Income Statement" by William Edwards, Iowa State University Extension and Outreach. Copyright © ISU Extension and Outreach.
Learning Objectives
4d Understand the accounting equation and all components.
4e Understand the components and uses of a balance sheet and Profit and Loss Statement.
Important Farm Financial Statements
The financial position and performance of a farm business can be summarized by four important financial statements. The relationship of these statements is illustrated below. Information from these statements can be used:
- to make important financing and investment decisions,
- to substantiate credit applications,
- to derive performance measures for analyzing the farm business,
- to develop budgets for planning purposes.
The major statements and their purposes are as follows:
Net Worth Statement - Summarizes the property and financial assets owned, the debts owed, and the net worth of the business at a point in time
Net Farm Income Statement - Summarizes the income generated, the expenses incurred, and the net income earned by the business during a period of time
Statement of Cash Flows - Summarizes all the sources and uses of cash by the business during a period of time
Statement of Owner Equity - Shows how net worth changed from the beginning to the end of the year
Your Farm Income Statement
How much did your farm business earn last year? Was it profitable? There are many ways to answer these questions.
A farm income statement (sometimes called a profit and loss statement) is a summary of income and expenses that occurred during a specified accounting period, usually the calendar year for farmers. It is a measure of input and output in dollar values. It offers a capsule view of the value of what your farm produced for the time period covered and what it cost to produce it. Most farm families do a good job of keeping records of income and expenses for the purpose of filing income tax returns. Values from the tax return, however, may not accurately measure the economic performance of the farm. Consequently, you need to have a clear understanding of the purpose of an income statement, the information needed to prepare the statement, and the way in which it is summarized.
A net farm income, as calculated by the accrual or inventory method, represents the economic return to your contributions to the farm business: labor, management, and net worth in land and other farm assets. Cash net farm income also can be calculated. It shows how much cash was available for purchasing capital assets, debt reduction, family living, and income taxes.
Preparing the Statement
The income statement is divided into two parts: income and expenses. Each of these is further divided into a section for cash entries and a section for noncash (accrual) adjustments.
An example income statement is shown at the end of this publication, along with a blank form. Blank forms for developing your own income statement are also available in ISU Extension and Outreach publication FM 1824/AgDM C3-56, Farm Financial Statements.
Most of the information needed to prepare an income statement can be found in common farm business records. These include a farm account book or program, Internal Revenue Service (IRS) forms 1040F Profit or Loss From Farming and 4797 Sales of Business Property, and your beginning and ending net worth statements for the year. If you use the IRS forms, you will need to organize the information a bit differently to make allowances for capital gains treatment of breeding stock sales, and the income from feeder livestock or other items purchased for resale.
Cash Income
Cash income is derived from sales of livestock, livestock products, crops, government payments, tax credits and refunds, crop insurance proceeds, and other miscellaneous income sources.
- Include total receipts from sales of both raised livestock and market livestock purchased for resale. Remember not to subtract the original cost of feeder livestock purchased in the previous year, even though you do this for income tax purposes. Also include total cash receipts from sales of breeding livestock before adjustments for capital gains treatment of income are made. These are termed “gross sales price” on IRS Form 4797.
- Do not include proceeds from outstanding USDA marketing loans in cash income even if you report these as income for tax purposes.
- Do not include noncash income such as profits or losses on futures contracts and options. However, do include cash withdrawn from hedging accounts.
- Do not include sales of land, machinery, or other depreciable assets; loans received; or income from nonfarm sources in income.
Adjustments to Income
Not all farm income is accounted for by cash sales. Changes in inventory values can either increase or decrease the net farm income for the year. Changes in the values of inventories of feed and grain, market livestock, and breeding livestock can result from increases or decreases in the quantity of these items on hand or changes in their unit values (see Example 1). Adjusting for inventory changes ensures that the value of farm products is counted in the year they are produced rather than the year they are sold. Subtract beginning of the year values from end of the year values to find the net adjustment.
Changes in the market values of land, buildings, machinery, and equipment (except for depreciation) are not included in the income statement unless they are actually sold. Accounts receivable and unpaid patronage dividends are included, however, because they reflect income that has been earned but not yet received.
Cash Expenses
All cash expenses involved in the operation of the farm business during the business year should be entered into the expense section of the income statement. These can come from Part II of IRS Schedule F. Under livestock purchases include the value of breeding livestock as well as market animals.
- Do not include death loss of livestock as an expense. This will be reflected automatically by a lower ending livestock inventory value.
- Income tax and Social Security tax payments are considered personal expenses and should not be included in the farm income statement, unless the statement is for a farm corporation.
- Interest paid on all farm loans or contracts is a cash expense, but principal payments are not.
- Do not include the purchase of capital assets such as machinery and equipment. Their cost is accounted for through depreciation. Land purchases also are excluded.
- You may wish to exclude wages paid to family members, because these also are income to the family.
- Include cash deposits made to hedging accounts.
Adjustments to Expenses
Some cash expenses paid in one year may be for items not actually used until the following year. These include feed and supply inventories, prepaid expenses, and investments in growing crops. Subtract the ending value of these from the beginning value to find the net adjustment (see Example 2).
Other expenses may be incurred in one year but not paid until the following year or later, such as farm taxes due, and other accounts payable. Record accounts payable so that products or services that have been purchased but not paid for are counted. However, do not include any items that already appear under cash expenses. Subtract the beginning total of these items from the ending totals to find the net adjustment. Note that interest expense due is not included until later, after net farm income from operations is calculated.
Depreciation is the amount by which machinery, equipment, buildings, and other capital assets decline in value due to use and obsolescence. The depreciation deduction allowed on your income tax return can be used, but you may want to calculate your own estimate based on more realistic depreciation rates. One simple procedure is to multiply the value of these assets at the end of the year by a fixed rate, such as 10%. This way you can group similar items, such as machinery, rather than maintain separate records for each item.
If you include breeding livestock under beginning and ending inventories, do not include any depreciation expense for them.
The beginning and ending net worth statements for the farm are a good source of information about inventory values and accounts payable and receivable. ISU Extension and Outreach publication FM 1791/AgDM C3-20, Your Net Worth Statement, provides more detail on how to complete a net worth statement. ISU Extension and Outreach publication FM 1824/AgDM C3-56, Farm Financial Statements contains schedules for listing adjustment items for both income and expenses. Use the same values that are shown on your beginning and ending net worth statements for completing adjustments to your net income statement for the year.
Summarizing the Statement
You have now accounted for cash farm income and cash expenses (excluding interest). You also have accounted for depreciation and changes in inventory values of farm products, accounts payable, and prepaid expenses. You are now ready to summarize two measures of farm income.
Net Farm Income from Operations
Subtract total farm expenses from gross farm revenue. The difference is the net income generated from the ordinary production and marketing activities of the farm, or net farm income from operations.
Interest Expense
Interest is considered to be the cost of financing the farm business rather than operating it. Net interest expense is equal to cash interest expense adjusted for beginning and ending accrued interest.
Capital Gains and Losses
Some years income is received from the sale of capital assets such as land, machinery, and equipment. The sale price may be either more or less than the cost value (or basis) of the asset.
For depreciable items the cost value is the original value minus the depreciation taken. For land it is the original value plus the cost of any nondepreciable improvements made. The difference between the sale value and the cost value is a capital gain or loss. For purposes of the farm income statement, capital gain would also include the value of “recaptured depreciation” from the farm tax return. Information for calculating capital gains and losses can come from the depreciation schedule and/or IRS Form 4797.
Sales of breeding livestock can be handled two ways: (1) record sales and purchases as cash income and expenses, and adjust for changes in inventory, or (2) record capital gains or losses when animals are sold and include depreciation as an expense. Either method can be used, but do not mix them.
Net Farm Income
Subtract interest expense, then add capital gains or subtract capital losses from net farm income from operations to calculate net farm income. This represents the income earned by the farm operator’s own capital, labor, and management ability. It also represents the value of everything the farm produced during the year, minus the cost of producing it.
Further Analysis
Net farm income is an important measure of the profitability of your farm business. Even more can be learned by comparing your results with those for other similar farms. ISU Extension and Outreach publication FM 1845/AgDM C3-55, Financial Performance Measures for Iowa Farms, contains information about typical income levels generated by Iowa farms. It also illustrates other important measures and ratios that can help you evaluate the profitability, liquidity, and solvency of your own business over time.
Other Financial Statements
Two other financial statements are often used to summarize the results of a farm business. While they are not as common as the net income statement and the net worth statement, they do provide useful financial information.
Statement of Cash Flows
A statement of cash flows summarizes all the cash receipts and cash expenditures that were received or paid out during the accounting year. It is sometimes called a flow of funds statement. Unlike the net income statement, it does not measure the profitability of the business. It merely shows the sources and uses of cash. The statement of cash flows is divided into five sections:
- cash income and cash expenses
- purchases and sales of capital assets
- new loans received and principal repaid
- nonfarm income and expenses (sole proprietor)
- beginning and ending cash on hand
If all cash flows are accurately recorded, the total sources of cash will be equal to the total uses of cash. If a significant difference exists, the records should be carefully reviewed for errors and omissions.
An example of a statement of cash flows is found at the end of this publication, along with a blank form.
Statement of Owner Equity
The statement of owner equity ties together net farm income and the change in net worth. Net worth will increase or decrease during the accounting year based on three factors:
- net farm income (accrual)
- net nonfarm withdrawals (nonfarm income minus nonfarm expenditures)
- adjustments to the market value of capital assets (affects market value net worth, only)
If these factors are recorded accurately and added to the beginning net worth of the farm, the result will equal the ending net worth.
Attributions
"Your Net Worth Statement" by William Edwards, Iowa State University Extension and Outreach. Copyright © ISU Extension and Outreach. Used with permission.
"Your Farm Income Statement" by William Edwards, Iowa State University Extension and Outreach. Copyright © ISU Extension and Outreach. Used with permission.
How is Interest Computed?
Excerpt used with permission from "Understanding the Time Value of Money" by Don Hofstrand,, Iowa State University Extension and Outreach Copyright © ISU Extension and Outreach.
Learning Objectives
4f Analyze financial statements.
4l Compute Interest.
Understanding the Time Value of Money
If I offered to give you $100, you would probably say yes. Then, if I asked you if you wanted the $100 today or one year from today, you would probably say today. This is a rational decision because you could spend the money now and get the satisfaction from your purchase now rather than waiting a year. Even if you decided to save the money, you would rather receive it today because you could deposit the money in a bank and earn interest on it over the coming year. So there is a time value to money.
Next, let’s discuss the size of the time value of money. If I offered you $100 today or $105 dollars a year from now, which would you take? What if I offered you $110, $115, or $120 a year from today? Which would you take? The time value of money is the value at which you are indifferent to receiving the money today or one year from today. If the amount is $115, then the time value of money over the coming year is $15. If the amount is $110, then the time value is $10. In other words, if you will receive an additional $10 a year from today, you are indifferent to receiving the money today or a year from today.
When discussing the time value of money, it is important to understand the concept of a time line. Time lines are used to identify when cash inflows and outflows will occur so that an accurate financial assessment can be made. A time line is shown below with five time periods. The time periods may represent years, months, days, or any length of time so long as each time period is the same length of time. Let’s assume they represent years. The zero tick mark represents today. The one tick mark represents a year from today. Any time during the next 365 days is represented on the time line from the zero tick mark to the one tick mark. At the one tick mark, a full year has been completed. When the second tick mark is reached, two full years have been completed, and it represents two years from today. Move on to the five tick mark, which represents five years from today.
Because money has a time value, it gives rise to the concept of interest. Interest can be thought of as rent for the use of money. If you want to use my money for a year, I will require that you pay me a fee for the use of the money. The size of the rental rate or user fee is the interest rate. If the interest rate is 10 percent, then the rental rate for using $100 for the year is $10.
Compounding
Compounding is the impact of the time value of money (e.g., interest rate) over multiple periods into the future, where the interest is added to the original amount. For example, if you have $1,000 and invest it at 10 percent per year for 20 years, its value after 20 years is $6,727. This assumes that you leave the interest amount earned each year with the investment rather than withdrawing it. If you remove the interest amount every year, at the end of 20 years the $1,000 will still be worth only $1,000. But if you leave it with the investment, the size of the investment will grow exponentially. This is because you are earning interest on your interest. This process is called compounding. And, as the amount grows, the size of the interest amount will also grow. As shown in Table 2.2.10a, during the first year of a $1,000 investment, you will earn $100 of interest if the interest rate is 10 percent. When the $100 interest is added to the $1,000 investment it becomes $1,100 and 10 percent of $1,100 in year two is $110. This process continues until year 20, when the amount of interest is 10 percent of $6,116 or $611.60. The amount of the investment is $6,727 at the end of 20 years.
| Year | Amount | Computation |
|---|---|---|
| 0 | $1,000 | |
| 1 | $1,100 | $1,000 x 10% = $100 + $1,000 = $1,100 |
| 2 | $1,210 | $1,100 x 10% = $110 + $1,100 = $1,210 |
| 3 | $1,331 | $1,210 x 10% = $121 + $1,210 = $1,331 |
| 4 | $1,464 | $1,331 x 10% = $133 + $1,331 = $1,464 |
| 5 | $1,611 | $1,464 x 10% = $146 + $1,464 = $1,611 |
| 6 | $1,772 | $1,611 x 10% = $161 + $1,611 = $1,772 |
| 7 | $1,949 | $1,772 x 10% = $177 + $1,772 = $1,949 |
| 8 | $2,144 | $1,949 x 10% = $195 + $1949 = $2,144 |
| 9 | $2,358 | $2,144 x 10% = $214 + $2,144 = $2,358 |
| 10 | $2,594 | $2,358 x 10% = $236 + $2,358 = $2,594 |
| 11 | $2,853 | $2,594 x 10% = $259 + $2,594 = $2,853 |
| 12 | $3,138 | $2,853 x 10% = $285 + $2,853 = $3,138 |
| 13 | $3,452 | $3,138 x 10% = $314 + $3,138 = $3,452 |
| 14 | $3,797 | $3,452 x 10% = $345 + $3,452 = $3,797 |
| 15 | $4,177 | $3,797 x 10% = $380 + $3,797 = $4,177 |
| 16 | $4,595 | $4,177 x 10% = $418 + $4,177 = $4,595 |
| 17 | $5,054 | $4,595 x 10% = $456 = $4,595 = $5,054 |
| 18 | $5,560 | $5,054 x 10% = $505 + $5,054 = $5,560 |
| 19 | $6,116 | $5,560 x 10% = $556 + $5,560 = $6,116 |
| 20 | $6,727 | $6,116 x 10% = $612 + $6,116 = $6,727 |
The impact of compounding outlined in Table 2.2.10a is shown graphically in Figure 2.2.10b. The increase in the size of the cash amount over the 20-year period does not increase in a straight line but rather exponentially. Because the slope of the line increases over time it means that each year the size of the increase is greater than the previous year. If the time period is extended to 30 or 40 years, the slope of the line would continue to increase. Over the long-term, compounding is a very powerful financial concept.
The effect of compounding is also greatly impacted by the size of the interest rate. Essentially, the larger the interest rate the greater the impact of compounding. In addition to the compounding impact of a 10 percent interest rate, Figure 2.2.10c shows the impact of a 15 percent interest rate (5 percent higher rate) and 5 percent (5 percent lower rate). Over the 20-year period, the 15 percent rate yields almost $10,000 more than the 10 percent rate, while the 5 percent rate results in about $4,000 less. By examining the last 10 years of the 20-year period you can see that increasing the number of time periods and the size of the interest rate greatly increases the power of compounding.
Table 2.2.10b shows the same compounding impact as Table 2.2.10a but with a different computational process. An easier way to compute the amount of compound interest is to multiply the investment by one plus the interest rate. Multiplying by one maintains the cash amount at its current level and .10 adds the interest amount to the original cash amount. For example, multiplying $1,000 by 1.10 yields $1,100 at the end of the year, which is the $1,000 original amount plus the interest amount of $100 ($1,000 x .10 = $100).
| Year | Amount | Computation |
|---|---|---|
| 0 | $1,000 | |
| 1 | $1,100 | $1,000 x 1.10 = $1,100 |
| 2 | $1,210 | $1,100 x 1.10 = $1,210 |
| 3 | $1,331 | $1,210 x 1.10 = $1,331 |
| 4 | $1,464 | $1,331 x 1.10 = $1,464 |
| 5 | $1,611 | $1,464 x 1.10 = $1,611 |
| 6 | $1,772 | $1,611 x 1.10 = $1,772 |
| 7 | $1,949 | $1,772 x 1.10 = $1,949 |
| 8 | $2,144 | $1,949 x 1.10 = $2,144 |
| 9 | $2,358 | $2,144 x 1.10 = $2,358 |
| 10 | $2,594 | $2,358 x 1.10 = $2,594 |
| 11 | $2,853 | $2,594 x 1.10 = $2,853 |
| 12 | $3,138 | $2,853 x 1.10 = $3,138 |
| 13 | $3,452 | $3,138 x 1.10 = $3,452 |
| 14 | $3,797 | $3,452 x 1.10 = $3,797 |
| 15 | $4,177 | $3,797 x 1.10 = $4,177 |
| 16 | $4,595 | $4,177 x 1.10 = $4,595 |
| 17 | $5,054 | $4,595 x 1.10 = $5,054 |
| 18 | $5,560 | $5,054 x 1.10 = $5,560 |
| 19 | $6,116 | $5,560 x 1.10 = $6,116 |
| 20 | $6,727 | $6,116 x 1.10 = $6,727 |
Another dimension of the impact of compounding is the number of compounding periods within a year. Table 2.2.10c shows the impact of 10 percent annual compounding of $1,000 over 10 years. It also shows the same $1,000 compounded semiannually over the 10-year period. Semiannual compounding means a 10 percent annual interest rate is converted to a 5 percent interest rate and charged for half of the year. The interest amount is then added to the original amount, and the interest during the last half of the year is 5 percent of this larger amount. As shown in Table 2.2.10c, semiannual compounding will result in 20 compounding periods over a 10-year period, while annual compounding results in only 10 compounding period. A shorter compounding period means a larger number of compounding periods over a given time period and a greater compounding impact. If the compounding period is shortened to monthly or daily periods, the compounding impact will be even greater.
| Compounding Annually | Compounding Semiannually | |||
|---|---|---|---|---|
| Year | Amount | Computation | Amount | Computation |
| 0 | $1,000 | $1,000 | ||
| 0.5 | $1,050 | $1,000 x 1.05 = $1,050 | ||
| 1 | $1,100 | $1,000 x 1.10 = $1,100 | $1,103 | $1,050 x 1.05 = $1,103 |
| 1.5 | $1,158 | $1,103 x 1.05 = $1,158 | ||
| 2 | $1,210 | $1,100 x 1.10 = $1,210 | $1,216 | $1,158 x 1.05 = $1,216 |
| 2.5 | $1,276 | $1,216 x 1.05 = $1,276 | ||
| 3 | $1,331 | $1,210 x 1.10 = $1,331 | $1,340 | $1,276 x 1.05 = $1,340 |
| 3.5 | $1,407 | $1,340 x 1.05 = $1,407 | ||
| 4 | $1,464 | $1,331 x 1.10 = $1,464 | $1,477 | $1,407 x 1.05 = $1,477 |
| 4.5 | $1,551 | $1,477 x 1.05 = $1,551 | ||
| 5 | $1,611 | $1,464 x 1.10 = $1,611 | $1,629 | $1,551 x 1.05 = $1,629 |
| 5.5 | $1,710 | $1629 x 1.05 = $1,710 | ||
| 6 | $1,772 | $1,611 x 1.10 = $1,772 | $1,796 | $1,710 x 1.05 = $1,796 |
| 6.5 | $1,886 | $1,796 x 1.05 = $1,886 | ||
| 7 | $1,949 | $1,772 x 1.10 = $1,949 | $1,980 | $1,866 x 1.05 = $1,980 |
| 7.5 | $2,079 | $1,980 x 1.05 = $2,079 | ||
| 8 | $2,144 | $1,949 x 1.10 = $2,144 | $2,183 | $2,079 x 1.05 = $2,183 |
| 8.5 | $2,292 | $2,183 x 1.05 = $2,292 | ||
| 9 | $2,358 | $2,144 x 1.10 = $2,358 | $2,407 | $2,202 x 1.05 = $2,407 |
| 9.5 | $2,527 | $2,407 x 1.05 = $2,527 | ||
| 10 | $2,594 | $2,358 x 1.10 = $2,594 | $2,653 | $2,527 x 1.05 = $2,653 |
Discounting
Although the concept of compounding is straight forward and relatively easy to understand, the concept of discounting is more difficult. However, the important fact to remember is that discounting is the opposite of compounding. As shown below, if we start with a future value of $6,727 at the end of 20 years in the future and discount it back to today at an interest rate of 10 percent, the present value is $1,000.
| Year | Amount | Computation |
|---|---|---|
| 20 | $6,727 | |
| 19 | $6,116 | $6,727 x .91 = $6,116 |
| 18 | $5,560 | $6,116 x .91 = $5,560 |
| 17 | $5,054 | $5,560 x .91 = $5,054 |
| 16 | $4,595 | $5,054 x .91 = $4,595 |
| 15 | $4,177 | $4,595 x .91 = $4,177 |
| 14 | $3,797 | $4,177 x .91 = $3,797 |
| 13 | $3,452 | $3,797 x .91 = $3,452 |
| 12 | $3,138 | $3,452 x .91 = $3,138 |
| 11 | $2,853 | $3,138 x .91 = $2,853 |
| 10 | $2,594 | $2,853 x .91 = $2,594 |
| 9 | $2,358 | $2,594 x .91 = $2,358 |
| 8 | $2,144 | $2,358 x .91 = $2,144 |
| 7 | $1,949 | $2,144 x .91 = $1,949 |
| 6 | $1,772 | $1,949 x .91 = $1,772 |
| 5 | $1,611 | $1,772 x .91 = $1,611 |
| 4 | $1,464 | $1,611 x .91 = $1,464 |
| 3 | $1,331 | $1,464 x .91 = $1,331 |
| 2 | $1,210 | $1,331 x .91 = $1,210 |
| 1 | $1,100 | $1,210 x .91 = $1,100 |
| 0 | $1,000 | $1,100 x .91 = $1,000 |
As shown in Table 2.2.10b, the compounding factor of annually compounding at an interest rate of 10 percent is 1.10 or 1.10/1.00. If discounting is the opposite of compounding, then the discounting factor is 1.00/1.10 = .90909 or .91. As shown in Table 2.2.10d, the discounted amount becomes smaller as the time period moves closer to the current time period. When we compounded $1,000 over 20 years at a 10 percent interest rate, the value at the end of the period is $6,727 (Table 2.2.10b). When we discount $6,727 over 20 years at a 10 percent interest rate, the present value or value today is $1,000.
The discounting impact is shown in Figure 2.2.10d. Note that the curve is the opposite of the compounding curve in Figure 2.2.10b.
The impact of discounting using interest rates of 5 percent, 10 percent, and 15 percent is shown in Figure 2.2.10e. The 15 percent interest rate results in a larger discounting impact than the 10 percent rate, just as the 15 percent interest rate results in a larger compounding impact as shown in Figure 2.2.10b.
Discounting Example
An example of discounting is to determine the present value of a bond. A bond provides a future stream of income. It provides a cash return at a future time period, often called the value at maturity. It may also provide a stream of annual cash flows until the maturity of the bond. Table 2.2.10e shows an example of a $10,000 bond with a 10-year maturity. In other words, the bond will yield $10,000 at maturity, which is received at the end of 10 years. The bond also has an annual annuity (an annuity is a stream of equal cash payments at regular time intervals for a fi xed period of time) equity to 10 percent of the value at maturity. So, the bond yields 10 $1,000 (10% x $10,000) annual payments over the 10-year period. Adding together the 10 $1,000 payments plus the $10,000 value at maturity, the future cash return from the bond is $20,000.
| Year | Annuity | Value at Maturity | Total |
|---|---|---|---|
| 0 | |||
| 1 | $1,000 | $1,000 | |
| 2 | $1,000 | $1,000 | |
| 3 | $1,000 | $1,000 | |
| 4 | $1,000 | $1,000 | |
| 5 | $1,000 | $1,000 | |
| 6 | $1,000 | $1,000 | |
| 7 | $1,000 | $1,000 | |
| 8 | $1,000 | $1,000 | |
| 9 | $1,000 | $1,000 | |
| 10 | $1,000 | $10,000 | $10,000 |
| Total | $10,000 | $10,000 | $20,000 |
To compute the current value of the bond, we must discount the future cash flows back to the time when the bond is purchased. To do this we must select an interest rate (called the discount rate when we are discounting).
In Table 2.2.10f, we have calculated the present value of the bond using discount rates of 5 percent, 10 percent, and 15 percent. First, let’s examine the computation using a 5 percent rate. Each of the $1,000 annuity payments is discounted to the present value. Note that the one year $1,000 annuity payment has a present value of $952 and the 10-year payment has a present value of $614. This is because the first-year payment is only discounted one time and the tenth-year payment is discounted 10 times over 10 years. The present value of all 10 annuity payments is $7,722. The present value of the $10,000 at maturity (after 10 years) is $6,139. Note that the present value of the $10,000 of annual annuity payments is greater than the $10,000 payment received at maturity because most of the annuity payments are discounted over time periods less than 10 years. The total present value of the annuity and the value at maturity is $13,861. So, the $20,000 of future cash payments has a value at the time of purchase of $13,861. Looking at it from a different perspective, if you paid $13,861 for this bond you would receive a 5 percent annual rate of return (called the internal rate of return) over the 10-year period.
| Year | Annuity | Value at Maturity | Total |
| Discount Rate = 5% | |||
| 0 | |||
| 1 | $952 | $952 | |
| 2 | $907 | $907 | |
| 3 | $864 | $864 | |
| 4 | $823 | $823 | |
| 5 | $784 | $784 | |
| 6 | $746 | $746 | |
| 7 | $711 | $711 | |
| 8 | $677 | $677 | |
| 9 | $645 | $645 | |
| 10 | $614 | $6,139 | $6,753 |
| Total | $7,722 | $6,139 | $13,861 |
If we increase the discount rate from 5 percent to 10 percent, the discounting power becomes greater. The present value of the bond drops from $13,861 to $10,000. In other words, if you want a 10 percent rate of return you can only pay $10,000 for the bond that will generate $20,000 in future cash payments. Note that the value at maturity dropped over $2,000 from $6,139 to $3,855. Conversely, the value of the annuity dropped from $7,722 to $6,145, a reduction of about $1,600.
| Year | Annuity | Value at Maturity | Total |
| Discount Rate = 10% | |||
| 0 | |||
| 1 | $909 | $909 | |
| 2 | $826 | $826 | |
| 3 | $751 | $751 | |
| 4 | $683 | $683 | |
| 5 | $621 | $621 | |
| 6 | $564 | $564 | |
| 7 | $513 | $513 | |
| 8 | $467 | $467 | |
| 9 | $424 | $424 | |
| 10 | $386 | $3,855 | $4,241 |
| Total | $6,145 | $3,855 | $10,000 |
If we increase the discount rate to 15 percent, the discounting power becomes even greater. The present value of the bond drops to $7,491. In other words, if you want a 15 percent rate of return you can only pay $7,491 for the bond that will generate $20,000 in future cash payments. Note that the value at maturity dropped from $6,139 (5 percent) to $3,855 (10 percent) to $2,472 (15 percent). The value of the annuity dropped in smaller increments from $7,722 (5 percent) to $6,145 (10 percent) to $5,019 (15 percent).
| Year | Annuity | Value at Maturity | Total |
| Discount Rate = 10% | |||
| 0 | |||
| 1 | $870 | $870 | |
| 2 | $756 | $756 | |
| 3 | $658 | $658 | |
| 4 | $572 | $572 | |
| 5 | $497 | $497 | |
| 6 | $432 | $432 | |
| 7 | $376 | $376 | |
| 8 | $327 | $327 | |
| 9 | $284 | $284 | |
| 10 | $247 | $2,472 | $2,719 |
| Total | $5,019 | $2,472 | $7,491 |
A bond is a simple example of computing the present value of an asset with an annual cash income stream and a terminal value at the end of the time period. This methodology can be used to analyze any investment that has an annual cash payment and a terminal or salvage value at the end of the time period.
Perpetuity
A perpetuity is similar to an annuity except that an annuity has a limited life and a perpetuity is an even payment that has an unlimited life. The computation of a perpetuity is straight forward. The present value of a perpetuity is the payment divided by the discount rate.
Time Value of Money Formulas
There are mathematical formulas for compounding and discounting that simplify the methodology. At right are the formulas, in which:
- “PV” represents the present value at the beginning of the time period.
- “FV” represents the future value at the end of the time period.
- “N” or “Nper” represents the number of compounding or discounting periods. It can represent a specific number of years, months, days, or other predetermined time periods.
- “Rate” or “i” represents the interest rate for the time period specified. For example, if “N” represents a specified number of years, then the interest rate represents an annual interest rate. If “N” represents a specific number of days, then the interest rate represents a daily interest rate.
If we are computing the compounded value of a current amount of money into the future, we will use the following formula. The future value “FV” that we are solving for is the current amount of money “PV” multiplied by one plus the interest rate to the power of the number of compounding periods. We are solving for the future compounded value (FV), in which the present value (PV) is $1,000, the annual interest rate (Rate) is 10 percent, and the number of time periods (Nper) is 20 years. This results in $1,000 multiplied by 6.727 and a future value of $6,727. Note that this is the same result as shown in Tables 2.2.10a and 2.2.10b.
To compute the discounted value of an amount of money to be received in the future, we use the same formula but solve for the present value rather than the future value. To adjust our formula, we divided both sides by (1 + Rate) Nper and the following formula emerges.
The present value (PV) of a future value (FV) of $6,727 discounted over 20 years (Npers) at an annual discount interest rate (Rate) of 10 percent is $1,000, the same as shown in Table 2.2.10d.
Time Value of Money Computation
A financial calculator or an electronic spreadsheet on a personal computer is a useful tool for making time value of money computations. For compounding computations, you enter the present value, interest rate, and the number of time periods, and the calculator or personal computer will compute the future value. The future value for the example below is $6,727, the same as the future value shown in Tables 2.2.10a and 2.2.10b.
Likewise, for discounting computations you enter the future value, interest rate, and the number of time periods, and the calculator or personal computer will compute the present value. The present value for the example below is $1,000, the same as the present value shown in Table 2.2.10d.
If an annuity is involved, you can use the payment function (PMT). In the example below, the present value is $10,000, the same as the present value of the bond example in Table 2.2.10f.
If an annuity is involved, you can use the payment function (PMT). In the example below, the present value is $10,000, the same as the present value of the bond example in Table 2.2.10f.
By using a financial calculator or spreadsheet, any of the values in the examples above can be computed as long as the other values are known. For example, the interest rate can be computed if the future value, present value, and number of time periods are known. The numbef or time periods can be computed if the present value, future value, and interest rate are known. The same is true if an annuity is involved.
Attributions
"Understanding the Time Value of Money" by Don Hofstrand, Iowa State University Extension and Outreach. Copyright © ISU Extension and Outreach. Used with permission.
The Five Cs of Credit
Learning Objectives
4j Discuss the importance of credit.
Five Cs of Credit Analysis
The Five Cs of Credit Analysis is an informal mnemonic of a set of risk factors that are commonly thought to be influential in determining the credit quality of a commercial borrower.
In alphabetical order, the Five Cs are commonly considered to be the following dimensions (with some variations in naming):
- Capacity
- Capital
- Character
- Collateral
- Conditions
Capacity
Capacity (sometimes replaced by Cashflow) refers to a borrower's ability to repay their debt, on the basis of their projected income profile and their other expenditures (including other debt). The key metrics used in evaluating credit capacity are ratios such as Debt to Income Ratio (DTI)—the balance between debt and income—or the Debt Service Coverage Ratio—a financial metric used to assess an entity's ability to generate enough cash to cover its debt service obligations. For individual borrowers, current income and employment history are good indicators of ability to repay outstanding debt. Income amount, stability over time, and type of income are important attributes. For corporate borrowers, important attributes include sources of revenue and profitability over time (such as that captured in net operating income).
In all cases there are two important approaches to evaluating capacity:
- historical ability to service the debt: such as that based on recent years cashflow metrics and compared to projected debt service,
- and projected ability to service debt: based on projected cashflows. Projected cashflows may be more faithful to evolving reality if they incorporate such things as a new project or new employment status. But they may also be subject to more uncertainty.
For longer maturity debt simple ratios may not be accurate indicators of credit capacity if the Contractual Cash Flows of the debt instrument are heavily skewed towards later periods. Contractual Cash Flows consist of the money exchanged between the parties who have signed a legal contract.
It is typically assumed that, all else being equal, a higher repayment capacity implies less credit risk.
Capital
Capital refers in general to the asset base (net worth) of the borrower and the degree to which it is committed to support a given amount of debt. When the borrowing concerns a specific project, capital refers the equity (own means) that the borrower invests in the project. For example, the down-payment on a mortgage for homeowners or the equity funds committed by a commercial borrower.
Capital influences credit risk in two ways:
- It provides a buffer in case income (cashflow) deteriorates.
- And it aligns the interests of the borrower with that of the lender.
A relative metric that captures the Capital dimension (typically used for corporate borrowers) is the Debt to Equity Ratio.
It is typically assumed that all else being equal a higher capital base committed implies less risk.
Character
Character refers to a borrower's overall behavioral profile towards repayment of debt. This assessment is made in relation to the dominant Credit Culture in a given jurisdiction and economic region. Credit Culture is the attitudes, beliefs, and behaviors that surround the use of credit in a society.
The assessment of credit character entails (in principle) both subjective and objective elements. Subjective elements require that the assessor (credit officer) has intimate knowledge of the borrower and may draw on qualitative arguments. Qualitative inputs may involve soliciting feedback from such entities as peers, community, clients, vendors that have had economic relationships with the borrower in the past.
In contrast objective elements do not require special insights and are more quantitative in nature. Objective inputs to the assessment of character include a borrower's Credit History, which provides evidence of past economic activities and also reflects the quality of the borrower's management ability. Credit History is a record of a person's or company's borrowing and repaying of money over time.
It is typically assumed that all else being equal a better character profile implies less credit risk.
Collateral
Collateral refers to any assets the borrower pledges as security for their borrowed funds. Assets may be financial in nature (such as securities) or real assets (such as real estate). It is the only one of the 5 Cs that is actually optional (as depending on the lending product, there might be no collateral pledged).
Collateral can be used in general Secured Lending, which involves business or personal loans that require some type of collateral as a condition of borrowing. But collateral is especially common in the financing of specific assets such as houses or automobiles for individuals, commercial real estate, and transport equipment for commercial borrowers. A key metric capturing the impact of collateral is the Loan to Value Ratio—the percentage of the value of a property that is borrowed as a loan.
It is typically assumed that, all else being equal, more collateral leads to lower realized losses in the case of a Default Event, which leads to a lower Loss Given Default—the share of an asset that is lost if a borrower defaults.
Conditions
Conditions is maybe the least well defined of the 5 Cs as it refers potentially on several distinct and unrelated aspects:
- the intended purpose of the loan (such as consumption or investment)
- the size of the loan and the interest rate (expressing the lender's Risk Appetite—the amount and type of risk that an organization is willing to take or retain in order to meet their strategic objectives)
- the relevant business and economic conditions (such as borrower specific, sectoral outlook, local economy, broader economy)
In general, using the funds for investment in a positive external environment would imply lower risk.
Usage
The Five Cs are typically used, explicitly or implicitly, in the construction of Credit Scorecards, with the significance of each "C" being assigned either subjectively or quantitatively.
Attributions
"Five Cs Of Credit Analysis" by Open Risk Manual contributors, Open Risk Manual is licensed under CC BY-NC-SA 4.0
Credit and Risk
Excerpt used with permission from "Financing Your Farm Business or Enterprise" by Robert E. Mikesell, Lynn Kime, PennState Extension. Copyright © PennState Extension.
Learning Objectives
4k Discuss the importance of returns, repayment ability, and risk.
Creditors and Lenders
In order to provide goods and services to their customers, businesses make purchases from other businesses. These purchases come in the form of materials used to make finished goods or resell, office equipment such as copiers and telephones, utility services such as heating and cooling, and many other products and services that are vital to run the business efficiently and effectively.
It is rare that payment is required at the time of the purchase or when the service is provided. Instead, businesses usually extend “credit” to other businesses. Selling and purchasing on credit means the payment is expected after a certain period of time, following receipt of the goods or provision of the service. The term creditor refers to a business that grants extended payment terms to other businesses. The time frame for extended credit to other businesses for purchases of goods and services is usually very short, typically thirty-day to forty-five-day periods are common.
When businesses need to borrow larger amounts of money and/or for longer periods of time, they will often borrow money from a lender, a bank or other institution that has the primary purpose of lending money with a specified repayment period and stated interest rate. If you or your family own a home, you may already be familiar with lending institutions.
The time frame for borrowing from lenders is typically measured in years rather than days, as was the case with creditors. While lending arrangements vary, typically the borrower is required to make periodic, scheduled payments with the full amount being repaid by a certain date. In addition, since the borrowing is for a long period of time, lending institutions require the borrower to pay a fee (called interest) for the use of borrowing.
Both creditors and lenders use financial information to make decisions. The ultimate decision that both creditors and lenders have to make is whether or not the funds will be repaid by the borrower. The reason this is important is because lending money involves risk. The type of risk creditors and lenders assess is repayment risk—the risk the funds will not be repaid. As a rule, the longer the money is borrowed, the higher the risk involved.
Recall that accounting information is historical in nature. While historical performance is no guarantee of future performance (repayment of borrowed funds, in this case), an established pattern of financial performance using historical accounting information does help creditors and lenders to assess the likelihood the funds will be repaid, which, in turn, helps them to determine how much money to lend, how long to lend the money for, and how much interest (in the case of lenders) to charge the borrower.
Creditor | Lender |
|
|
Credit Score
Before applying for any loan be sure to check your credit score. This includes checking your credit history with all three of the major credit-reporting agencies—Experian, Equifax and TransUnion. Credit score information can be accessed from each agency once annually free of charge, but this service will not include an actual credit score, so check one every four months to catch inaccuracies as soon as possible. Contact the credit reporting agencies immediately about anything on the report that you do not agree with. Keep in mind that scores "purchased" online do not always accurately reflect what the bank sees when it pulls your credit history.
Financing
The type of financing you apply for will depend on the type of farm you are going to buy or enterprise you are considering, as well as your specific needs and circumstances. If you are considering a new business, you will require business financing and at least a rudimentary business plan, which should include:
- a brief narrative that describes your farm business plan and your experience to carry it off
- projected income from each enterprise (For example, stall rent—X number of horses at Y dollars a month each, land or barn rental, or crop income—X acres of corn at Y bushels per acre at Z price.)
- a thorough expense sheet for each enterprise
- any existing business or "projected income" that will remain (It helps to have obtained the seller's tax return to validate actual revenue history).
A thorough business plan that shows income to offset the expenses will strengthen the loan application. Providing as much detail as possible will only strengthen your application so be sure to include both income and expenses, as well as potential profit or lack of profit for the first year. Any off-farm household income that can support loan payments also needs to be included and proven by recent tax returns. You will be required to submit a balance sheet showing all assets and liabilities as a portion of your application.
Most agricultural lenders know that a farm business or enterprise may not be profitable the first year, so having three years of projections will tell the lender when they may expect to see income that will support the loan payments.
Different types of farm loans are set up for different types of farming operations. Be sure to match the loan type and repayment structure to the use of the funds. Main choices are operating loans, term loans, and residential loans.
Operating loans usually provide a line of credit to be paid back (typically at prime rate) once the farmer receives revenue, such as for a crop. These loans are designed to be used on crop or livestock production expenses and repaid each year. You may need to obtain annual operating loans, but this will strengthen your credit and relationship with the lender. An operating loan would typically be used to begin a new enterprise.
Term loans are usually for infrastructure and building improvements. Most banks match the length of the loan to the projected depreciation value or life expectancy of the purchase. For example, a loan for a tractor may have a seven-year term, while real estate may have a twenty to thirty-year repayment schedule.
Residential loans usually have a lower interest rate and are easier to obtain than business loans and may be the way to go if the farm is being purchased primarily for residential purposes with farming as a sideline. If the farm is residential but also commercial then the loan is considered commercial. The required down payment for these types of loans is generally 20 percent, but other lending sources may provide funding for the initial down payment.
Cost of a Loan
A good rule of thumb for figuring how much a loan will cost a borrower in the long run is to consider that a 20-year loan will roughly double the initial cost of that loan. For instance, an initial $100,000 loan will ultimately cost the borrower about $200,000, while a 30-year payback will approximately triple the initial loan amount. While the actual repayment time and cost will fluctuate with interest rates, the above gives a pretty good example of the differences in actual costs associated with typical mortgage loan life spans. You may consider starting with a longer-term loan to keep payments low during the start-up period then refinance when a more predictable and steady income is achieved.
When it comes to loans for farming operations, many choices exist with an even greater number of possibilities. The larger your initial down payment at the time of establishing the loan, the lower your repayment and interest rate will be. The more "skin you have in the game" the less risk the lender is assuming.
Conventional Financing
Beginning farmers who have some equity may qualify for financing from traditional lenders. Undoubtedly, conventional financing through local commercial banks or through the Farm Credit system is the simplest, most straight-forward route. These institutions carry a variety of financial products, but often will not finance more than 80% of a farming venture's start-up cost. Many times loans can and will be combined with funding from various small business administrations, economic development organizations, and funding agencies. Most loan officers should be able to steer you in the right direction for these opportunities. But there are other options for the remainder of the down payment, such as USDA assistance.
US Department of Agriculture (USDA) Financing
The Federal government has noted the ageing demographics of our agricultural producers and offers a variety of affordable financing options to help new producers get started. Farm Service Agency (FSA)—the branch of USDA that distributes and services farm loans—provides a step-by-step approach and resources to plan and finance a farming career. They offer many services to farmers above the loan programs and should be a stop on your farm financing journey.
FSA can provide both farm ownership and operating loans for both new and established producers. Additionally, FSA can co-fund with, or guarantee loans from, conventional lenders. As with any government program, the application process for farm ownership and large operating loans can be a bit cumbersome. FSA also offers a Microloan program for farm ownership or operating expenses, with a $50,000 limit. Microloans have a streamlined application process and can be a nice fit for many producers. You can now apply for two microloans for a total of $100,000: one for land and one for equipment or operating expenses. Another benefit of the Microloan program is that the item being purchased with the loan may be used as collateral.
Other Financing Options
Sometimes new farmers can align themselves with a retiring farmer who agrees to finance the operation until the new farm gets on solid financial footing. PA Farm Link is one such organization that helps align established farmers with new ones.
Final Thoughts
Navigating the financing challenges is just one hurdle for new and beginning farmers, but it is among the more important. There are lots of resources out there but accessing them and determining which ones are applicable in each situation requires some study. Just be careful to work with someone who understands what you are planning. Agriculture is a unique industry and requires some understanding of production cycles and potential hazards. When drafting your business plan be sure to include a risk management plan to show the lender you have considered that something may not go as planned. This will demonstrate that you have conducted your research and understand the industry.
Cash is king, but not always practical. You will need to be sure you have funding for several years as most businesses fail due to the lack of capital funding. Borrowing funds is never easy but is almost always necessary. It will not happen overnight so begin the process several months before you anticipate needing the funds.
Attributions
"Principles of Accounting, Volume 1: Financial Accounting" by Mitchell Franklin, Patty Graybeal, Dixon Cooper, OpenStax is licensed under CC BY-NC-SA 4.0
Access for Free at https://openstax.org/books/principles-financial-accounting/pages/1-4-explain-why-accounting-is-important-to-business-stakeholders
"Financing Your Farm Business or Enterprise" by Robert E. Mikesell, Lynn Kime, PennState Extension.Copyright © PennState Extension. Used with permission.