Introduction to Financial Analysis of a Farm Business
Farm Business Management Update, June/July 2006
By Alex White (firstname.lastname@example.org), Extension Specialist, Finance, Department of Agricultural and Applied Economics, Virginia Tech
A common mistake in evaluating the condition of a farm is to focus strictly on the production side of the operation. Success tends to be measured in terms of bushels/acre, pounds of feed/pound of gain, and other production measures. After all, thatís what the manager actually produces and sells; thatís the hands-on part of the business Ė growing things! While managers need to be proficient in the production aspect of the farm, they must also be proficient in the business side of the operation, which includes financial management, marketing, labor management, and risk management. Let's take a quick look at the basics of financial analysis of a farm business.
Financial analysis is a powerful management tool. I use the basics of financial analysis to identify the main strengths and weaknesses of a farm operation. The ratios and measures I like to use help me uncover potential problems with the operation, whether it is cost control, debt management, marketing issues, or even production management problems. Once I have identified potential problems, I can dig a little bit deeper to try to identify the underlying problem(s). I have used these methods in several consulting cases for farms across the U.S. These cases have involved a wide variety of operations Ė beef, dairy, hog, poultry, row-crop, equine, and on-farm marketing. Iíll be the first to admit that I am not an expert in the production management of any of these operations. BUT I don't have to be a production expert to help a manager improve the operation. All I need are good financial information, a few financial ratios, and common sense!
What can you actually learn about a farm operation through financial analysis? The answer is, "Plenty!" It can provide valuable insight about an operation:
|- Liquidity||Current ratio, Working Capital|
|- Solvency||Debt/Asset ratio, Percent Equity ratio, Leverage ratio|
|- Repayment ability||Debt Coverage ratio|
|- Profitability||Net Farm Income, Return on Assets, Operating Profit Margin|
|- Financial efficiency||Asset Turnover ratio, Expense/Receipt ratio, Interest Exp/Receipt ratio|
|- Collateral position|
Agricultural loan officers commonly use these areas to analyze loan applications. By looking at all these ratios together, you can get a sound, comprehensive overview of the entire operation.
But that's not all the good information managers can get from financial analysis. A manager can use financial records to determine the most profitable level of input to use (marginal analysis). For example, a manager can look at the question, "Should I apply 80 pounds of fertilizer or 100 pounds of fertilizer per acre?" A manager can also estimate the breakeven analysis. Breakeven analysis tells the manager the minimum yield per acre or the minimum price per unit needed to cover the costs of production Ė a very powerful management tool!
From a farm planning viewpoint, a manager can use financial records to develop a long term operating plan for the farm, including enterprise analysis and whole farm planning. Enterprise analysis helps a manager determine the profitability of each enterprise, as well as potential methods for improving the profitability. Enterprise analysis also lets a manager compare different production systems. For example, managers can look at the profitability of conventional till corn versus no-till corn; enterprise budgets for each production system will allow them to examine the inputs needed, the expected output (yield), and other aspects of the enterprise. Whole farm planning is a method of determining the most profitable enterprise mix, given the resources for the operation. Whole farm planning can be as simple as constructing a whole farm budget (from a series of enterprise budgets), or it can involve more complex methods such as linear programming or simulation analysis.
And finally, financial analysis provides a manager with powerful aids in decision making. Two of my favorite decision making aids are partial budgets and cash flow statements. A partial budget is a quick, simple method for analyzing small changes in an operation. A cash flow statement is a monthly (or quarterly) listing of all the cash inflows and outflows, showing the expected cash surplus or deficit each period. In my opinion, the cash flow statement is the most powerful and most useful financial statement in the day-to-day operations of a farm or business.
What do you need to complete a financial analysis of an operation? In a nutshell, managers need a good, accurate record keeping system. More specifically, their record keeping system should allow you to generate the following financial statements:
In addition, managers can do a more complete analysis if you have enterprise budgets for each of the main enterprises on the farm, production records, and a whole farm budget. This information allows them to calculate all of the financial ratios and measures mentioned above. It will also enable marginal analysis and breakeven analysis and partial budgeting.
This has been a brief overview of financial analysis for a farm operation. Future articles will explore the above-mentioned topics in more detail to help managers analyze a farm situation from a financial point of view. Also coming in the future -- look for a web site with in-depth discussion and examples of each of these topics, as well as links to spreadsheet-based decision making aids.
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