Financial Analysis of an Agricultural Business - the Income Statement
Farm Business Management Update, October/November 2006
By Alex White (firstname.lastname@example.org), Instructor, Agricultural Finance and Small Business, Department of Agricultural and Applied Economics, Virginia Tech.
My previous article briefly discussed the agricultural balance sheet – what it is and what you can learn from it. Now I’ll focus on another major financial statement: the income statement. To most producers, this statement is important because it shows the bottom line – how much net income, or profits, the business made during the year. The income statement is also called the Profit and Loss Statement, or the P&L for short. I use the income statement to analyze the profitability of the operation. When used in tandem with a balance sheet and a cash flow statement, I can get a good picture of the repayment ability of the operation as well.
An income statement is a listing of all the business-related incomes (revenues) and expenses for one year. It only includes incomes and expenses that stem from the business – household and family items are not included on an income statement. To simplify the process, I typically use an IRS Schedule C (Business Profit/Loss) or Schedule F (Farm Profit/Loss) as a proxy for an income statement. These tax schedules clearly lay out what items should be included on an income statement.
Unlike a balance sheet that is constructed for a given day, the accounting period for an income statement is one year. You can construct them for shorter time periods (a week, a month, a quarter, etc.), depending on the particular business. Similar to balance sheets, two methods are used to construct an income statement – the cash method and the accrual method. In a nutshell, the cash method records incomes and expenses when cash changes hands; the accrual method, which is more accurate, records incomes and expenses when a transaction takes place. For example, suppose I buy $10,000 of supplies on December 5, 2006, but don’t actually pay for the supplies until January 5, 2007. Under the cash accounting method, the supplies expense will be recorded in January 2007; under the accrual method, the supplies expense is recorded in December 2006. Due to the simplicity of the cash method, and the fact you can play more “tax games” using the cash method, it is the most common accounting method I usually see. From an analysis point of view, I would rather have accrual method income statements, as they provide a much more complete picture of the business’ financial situation.
The first section of an income statement is the income section. This section will include all the revenues that are generated by the normal operations of the business. Examples include gross income from the sale of crops, feeder livestock, livestock products such as milk, and any income from custom work performed. Any income from government programs or cooperative distributions may also be listed in this section. If managers use the accrual accounting method, they need to adjust the income for changes in the value of their inventories. A common mistake in listing incomes under the cash method is to include proceeds from the sale of a capital asset – these do not go on an income statement. They are listed on IRS Form 4562 because they are not incomes from normal operations of the business. Once all the incomes are listed, they are totaled to get Gross Income.
For most farms, the next section of the income statement is the expense section. This section clearly lists all of the main expense categories for a farming operation, such as chemicals, feed, fertilizer and lime, freight, labor expense, interest expense, and seed and plants. These items are all cash expenses for the operation. In addition, this section also includes depreciation expense – a non-cash expense. Depreciation estimates the loss of value for productive assets (calculated using IRS guidelines). Please note, income taxes are NOT listed as an expense on an income statement. After everything is listed, I calculate the total expenses by summing all the expenses.
For an agribusiness that manufactures a product or buys products for resale, the next section of the income statement is the “cost of goods sold” section. This section clearly shows the cost of producing or buying the products. For example, if I purchase sweet corn for $1.50/dozen and resell it for $2.00/dozen, my cost of goods sold is $1.50/dozen. Or if my florist business buys various inputs (flowers, baskets, vases, hired labor, etc.) for $5 per arrangement and sells the arrangements for $15 apiece, my cost of goods sold is $5 per arrangement.
After all of the incomes and expenses (and accrual adjustments) are completed, I can calculate the main financial profitability measure – Net Income. Net Income is calculated by subtracting total expenses from total income. In the business world, we call it Earnings Before Taxes (EBT). Obviously, we like to see Net Income or EBT greater than zero!
A Net Income greater than zero indicates that we generated enough revenues to cover our total expenses (including depreciation). Net Income greater than zero leads to a big issue that people have with profit calculations. Producers will tell me that at the end of the year their cash income is greater than their cash expenses, so they had a profitable year. They have more cash on hand than they started with, so everything is just great! My answer is, “Don’t forget about depreciation!!” Producers often focus on cash only, and they forget about depreciation. Since a check isn’t written to anyone to pay depreciation expense, forgetting is understandable. But depreciation expense must be covered over time!
Consider this situation – a business has total income of $100,000, cash expenses of $80,000 and annual depreciation expense of $30,000. Producers tend to see profits of $20,000 ($100,000 - $80,000), when in reality they have a “loss” of $10,000 ($100,000 – $80,000 – $30,000). Yes, they may have more cash on hand, but the value of their machinery and facilities has decreased by $30,000 (depreciation). The overall condition of the business is decreasing over time – if depreciation can’t be covered, the asset base cannot be maintained at its current level; equipment cannot be replaced or facilities repaired over time. The business is slowly losing productive power. Total expenses must be covered, including depreciation, to stay in business for the long run!
Another common measure of profitability that we can get from an income statement is the Rate of Return on Sales (ROS). There are several methods of calculating ROS – I take the easy method and divide Net Income by Gross Sales (or Gross Income). This ratio tells how much profit is generated by each dollar of sales. Again, the higher, the better. The benchmark for this ratio varies for each industry. I use the Annual Statement Studies (Robert Morris Associates) to find the appropriate benchmark for a specific industry.
I can use the incomes statement in combination with the balance sheet to calculate other profitability measures, such as Rate of Return on Assets (aka ROA) and the Rate of Return on Equity (ROE). I’ll discuss these ratios in a future article.
When producers talk about the bottom line, they are usually talking about net cash income (cash income minus cash expenses). I would highly recommend that producers go one step further and consider their net income (total income minus total expenses, including depreciation) to get a more accurate picture of the profitability of their businesses.
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