Financial Analysis Using Your Schedule F

Financial Analysis Using
Your Schedule F
Paul Dietmann, Emerging Markets Specialist
Badgerland Financial
A little about your presenter
What is Badgerland Financial?
– Rural lending (& other financial services) cooperative
– Farm Credit System association
– 300+ employees
– Serves 33 counties in Southern Wisconsin
– 15,000 members
– Largest ag lender in Wisconsin
– Paid $9.55 million in cash dividends to
farmers/members for 2013 business
Filing a farm income tax return is a wonderful
thing!
• Forces us to keep good records
• Forces us to track cash farm income
• Forces us to track cash farm expenses
• Forces us to think about depreciation
• Usually done on a calendar-year basis, which
makes it easy to do year-to-year comparison
Hurrah for taxes!!
And we
end up
with this
document
5
What we’re going to cover in this
presentation…
• How to use the Schedule F for business
management—not tax management—
purposes
• How to create and evaluate an annual
balance sheet
• How to put the Schedule F together with the
balance sheet to analyze your farm’s
finances
We really want to analyze two things
• #1 is Cash Flow - The ability of the farm to
generate enough cash to cover all expenses
and loan payments, and have enough left to
pay for family living costs and reinvestment
in the farm.
We really want to analyze two things
• #2 is Profitability - The ability of the farm to
generate an adequate rate of return on the
investment of money and time devoted to
the business
Cash Flow and Profitability
• Related but very different
– Can have strong cash flow and be unprofitable
– Can be profitable with negative cash flow
• Cash flow is critical in short run
• Profitability and cash flow are both important
for the farm to be sustainable
We have to massage the Schedule F a bit
• It’s not really a Statement of Cash Flows…it
excludes some cash items and includes noncash items
• It’s not really an Income Statement…it
doesn’t account for changes in inventories,
accounts receivable, payables, etc.
• With a little work we’ll turn it into something
good
Income questions
• Is this a typical year’s income?
– Did you receive payment in 2013 for stuff sold in 2012?
– Are you still waiting to be paid for stuff you produced and
sold in 2013?
– Are there other items you typically sell that don’t show
up on Schedule F?
• Were there items you produced but didn’t
sell? (home consumption, barter, provided
to farm interns, etc.)
Expense questions
• Are any expenses artificially inflated?
–
–
–
–
Charged to the farm but actually personal
Prepaid supplies during the year
Two years’ of property taxes paid in one year
Big, unusual repair bills
• Any expenses artificially low?
– Using up supplies purchased the year before
– Not fully accounting for labor cost
The Balance Sheet
The Balance Sheet
A snapshot of the investment in the farm business
(assets) and the financing methods used (a
combination of liabilities and owner’s equity).
A balance sheet measures
the financial position of your farm.
The Balance Sheet
• Assets – Everything that is owned by or payable
to the business on the date the balance sheet is
prepared
• Liabilities – All obligations owed by the business
on the balance sheet date
• Owner’s Equity or Net Worth – Total assets minus
total liabilities
Items with a star need to be “accrual adjusted” on
the Income Statement
18
Information from balance sheet
• Liquidity – Ability of the business to meet its
current (short term) liabilities with current assets
• Solvency - Ability of the business to pay off all of its
debts if it were to be sold tomorrow
8 more
buckets of
liquid assets!
Liquidity
• Current assets: Cash and anything that will either
be converted to cash or used up within a year
–
–
–
–
Crop and feed inventories, market livestock inventories
Growing crops
Accounts receivable
Prepaid expenses and supplies
Liquidity
• Current liabilities: Anything that is due now or will
come due within a year
–
–
–
–
Accounts payable
Principal due within a year on term loans
Accrued interest on term loans
All principal and accrued interest on operating loans
Liquidity ratios
• Current ratio – Current assets divided by
current liabilities
GOAL: The current ratio needs to be at least 1.0, preferably
2.0 or more
• Working capital – Current assets minus current
liabilities
GOAL: Working capital at least 15% of annual gross farm
income
Working capital is a key measure of risk
Current Assets – Current Liabilities = Working Capital
Net working capital should be at least 15% of the
annual gross revenue of the farm
Strong working capital position allows the farm to:
a) withstand an unexpected setback
b) take advantage of an unexpected opportunity
WORKING CAPITAL EXAMPLE
Our net working capital in this example is -$1,534
If annual gross revenue of the farm is $45,000, our net working capital
should be $6,750 (15% of annual gross revenue). We are $8,284 short
We would want to see the deficit made up over four years from cash flow
$8,284 ÷ 4 years = $2,071/year that needs to come from cash flow
Common liquidity problems
Working capital consists mainly of feed
inventories and receivables, not much cash
Spending too much cash on capital purchases
instead of building working capital reserves
Operating losses carried forward year-to-year
Poorly structured debt
Large, unplanned expenses
Solvency ratios
• Equity-to-Asset ratio – Owner’s equity divided by
total assets.
GOAL: Should be greater than 50%
• Debt-to-Equity ratio – All farm liabilities divided by
owner’s equity.
GOAL: Should be 43% or less over the long run. It can be
higher in the short-run.
Common solvency problems
Taking on longer term debt to cover for negative
cash flow
Erosion in market values of assets
Assets depreciating faster than the loan balances
are being paid off
Now that we have our Schedule F and our balance
sheet, let’s analyze profitability
The Income Statement
One year’s income and expenses, and how much
profit was generated by the farm.
It’s not a cash flow statement…it includes non-cash
items.
(The Income Statement is also known
as a “Profit and Loss” statement)
Why do we need an income statement?
• Gives us a way to account for everything of value
generated by the farm during the year, not just
the cash it brought in.
• Gives us a way to account for all expenses
incurred, not just those that were paid in cash.
• Tells us if the farm is generating an adequate
return for the farmer’s devotion of time and
money…Is the farm profitable?
How do we measure profitability?
• Rate of return on farm assets – The “interest rate” being
earned on all of the investments in the farm. GOAL: Higher
than interest on borrowed money
• Rate of return on farm equity – The “interest rate” being
earned on YOUR investment in the farm. GOAL: Higher than
ROROA
• Operating profit margin – Net farm income divided by gross
farm income. GOAL: 20% +
The Income Statement
Income – Includes cash sales of farm products,
government payments, custom work income. Also
includes changes in inventories of feed, crops, and
livestock, and changes in prepaid expenses, accounts
receivable, payables, and accrued interest.
Expenses – Includes all cash operating expenses
including interest (but not principal) payments. It also
includes depreciation.
Income Statement
Income
Vegetable sales $45,000
GROSS FARM INCOME $45,000 (Sch. F, line 9)
Expenses
Schedule F cash operating expenses $19,650 (Sch. F expenses minus depreciation)
Interest on farm loans $10,000 (Sch. F line 21)
TOTAL CASH FARM EXPENSE $29,650
Net CASH Farm Income $15,350
Change in prepaid expenses +/Change in accounts receivable +/Changes in other accruals +/Total accrual adjustments
$ ----
(Jan. 1 2013 & 2014 balance sheets)
Economic depreciation (balance sheet)
Machinery $30,000 x 15% = $4,500
Buildings $20,000 x 5% = $1,000
-Economic depreciation $5,500
NET FARM INCOME $9,850
Rate of Return on Assets
Net Farm Income
+ Farm interest
- Value of farmer’s labor
Return on farm assets
$ 9,850
$10,000
$18,000
$1,850
$1,850/$185,000 (total farm assets) = 1%
ROROA should be higher than the interest rate on farm loans
34
Rate of Return on Equity
Net Farm Income
$ 9,850
- Value of farmer’s labor $18,000
Return on farm equity -$8,150
-$8,150/$15,000 (farm net worth) = -54%
Rate of Return on Equity should be higher than ROROA
35
Operating profit margin
Return on farm assets
Value of farm production
$1,850/$45,000 = 4.1%
36
Operating Profit Margin should be better than 20%
Income
Vegetable sales $45,000
GROSS FARM INCOME $45,000
Expenses
Schedule F cash operating expenses $19,650
Interest on farm loans $10,000
TOTAL CASH FARM EXPENSE $29,650
Net CASH Farm Income $15,350
Change in prepaid expenses +/Change in accounts receivable +$5,000
Change in crop inventory +/+Total accrual adjustments $5,000
-Economic depreciation $5,500
NET FARM INCOME $14,850
Economic depreciation
Machinery $30,000 x 15% = $4,500
Buildings $20,000 x 5% = $1,000
Rate of Return on Assets now
Net Farm Income
+ Farm interest
- Value of farmer’s labor
Return on farm assets
$14,850
$10,000
$18,000
$6,850
$6,850/$185,000 (total farm assets) = 3.7%
38
ROROA should be higher than the interest rate on farm loans
Common profitability issues
•
•
•
•
•
Capital investment too high relative to income
Depreciation too high
Putting too little—or no—value on farmer’s labor
Failing to account for changes in accrual items
Operating expenses too high, particularly feed,
labor, & interest
• High market values for assets (Makes it difficult to
achieve adequate rates of return on assets & equity)
Cash flow analysis
Annual Statement of Cash Flows
All cash flowing into the operation (including loan
proceeds) and all cash flowing out (including family
living expenses, taxes, principal and interest
payments) on an annual basis.
Where is the farm’s cash coming from? Is
there enough cash to cover operating
expenses, income taxes, family living costs,
and loan payments, and still have money
left to replace stuff that’s rusting, rotting, or
wearing out?
Overly Simple Statement of Cash Flows
Beginning cash balance
$5,000
Net cash farm income
$15,350
Nonfarm income
$--0--
Net cash available
$20,350
Family living draw
($18,000)
Income taxes & SS
$--0--
Cash avail for principal pymts $2,350
+ Farm interest paid
Cash available for P & I
Scheduled P & I payments
Cash surplus or deficit
$10,000
$12,350
($16,534)
($4,184)
From the
Income
Statement
We need a bit more detail
• Beginning cash balance
• Cash flow from operations
• Cash flow from investing activities
• Cash flow from financing activities
• Net change in cash
• Ending cash balance
Annual statement of cash flows
Beginning cash balance
$5,000
Cash flow from operations
Vegetable sales
Farm operating expenses
Net cash from operations
$45,000
($19,650)
$25,350
Cash flow from investing
Capital purchases
Capital sales
Net cash from investing
($ 0)
$ 0
$ 0
Cash flow from financing
Proceeds from new loans
Loan payments
Off-farm wages
Family living draw
Net cash from financing
$ 0
($16,534)
$ 0
($18,000)
($34,534)
Net change in cash
Ending cash balance
($9,184)
($4,184)
Key cash flow ratio
• Capital Debt Repayment Capacity (CDRC) – Cash
available for debt repayment divided by total demands
on available cash*. GOAL: Higher than 115%
*net cash farm income minus family living expenses and income taxes, plus interest on capital debt
scheduled P & I payments plus cash needed for both Capital Asset Replacement and working capital
Capital Debt Repayment Capacity
CDRC should be
higher than 115%
Machinery $30,000 x 15% =
Bldgs $20,000 x 5% =
4,500
1,000
$5,500
Breakdown for Line 13: Principal and Interest $16,534
$150,000 mortgage, 6% interest, 20-yr amortization
$20,000 machinery note, 5% interest, 7-yr am.
$13,078
$3,456
P & G’s CDRC with extra $5,000 farm income &
$18,000 non-farm income
Machinery $30,000 x 15% =
Bldgs $20,000 x 5% =
$5,500
4,500
1,000
CDRC should be higher than 115%
Common cash flow problems
• Volatile prices for farm production and inputs combined
with relatively high debt load
• Too little working capital reserves
• Overly optimistic cash flow projections
• Loss of off-farm income
• Sometimes a debt structure problem; more likely it’s the
debt level rather than structure
• Rarely a problem of family living expenses being too high
A few final suggestions
• Quality of life should be #1 business goal
• Need to have positive cash flow to keep doing
what you love to do
• Doesn’t make sense to borrow money at 6% to
achieve a 3% ROROA or ROROE
• Always do a January 1 balance sheet
• Don’t draw any big conclusions from one year’s
financials
49
Thank You!
Paul Dietmann
Badgerland Financial
(608) 370-6956
[email protected]