Download Farm Financials Starting with Schedule F

Farm Financials:
Starting with Your
Schedule F and
Building from There
Paul Dietmann, Emerging Markets Specialist
Badgerland Financial
[email protected]
608-370-6956
New Farmer U
Lanesboro, MN
October 21, 2016
Badgerland Financial
– Rural lending (& other financial services) cooperative
– Farm Credit System association
– 350 employees, 17 offices
– Serves 33 counties in Southern Wisconsin
– 16,000 members
– Largest ag lender in Wisconsin
– Paid $13.5 million in cash dividends to
farmers/members for 2015 business
What we’re going to cover this morning…
• How your Schedule F can be used for business
management—not just tax management—purposes
• Cash flow and profitability; they’re two different
things
• How to evaluate your farm’s cash flow
• An overview of the annual balance sheet
• Using the Schedule F and balance sheets to create
an income statement & determine profitability
Our example farm: Happy Farmer CSA
Happy Farmer has 150 members and also sells through farmers’
markets and some wholesale accounts.
The Happy Farmer purchased its farm a few years ago and has a
mortgage on it. There is a modest line of equipment and a few
small outbuildings. There is no debt other than the mortgage.
Happy Farmer’s owners feel like the farm is doing okay
financially. They keep up on invoicing, pay most bills on time, and
keep records that are good enough to get their taxes done.
However, after paying all of the bills, there isn’t much left. They
want to know if all their hard work is worthwhile.
Their Schedule F shows a profit of
$44,312 but they definitely aren’t ending
up with an extra $44,312 in their
checking account at the end of the year.
What’s the deal?
Let’s look more closely at the Schedule F
• Most of the entries are based on cash that came in
or was paid out during the year
• A big exception is depreciation, a non-cash expense
that can vary a lot from year to year
• It only pertains to the farm business; the farm
family’s personal expenses aren’t included
Using the Schedule F for business
management purposes
• Need to ensure that it’s an accurate picture
– Of the year’s income
– Of the year’s expenses
Schedule F farm income
Income questions
• Is this a typical year’s income?
– Did you receive payment in 2014 for items sold in 2013?
– Are you still waiting to be paid for stuff you produced and
sold in 2014?
– Are there other items you typically sell that don’t show
up on Schedule F?
• Were there items you produced but didn’t
sell? (vegetables consumed at home, donated to food
pantries, bartered, added to inventory, provided to
members, friends, family, etc.)
Schedule F farm expenses
Only the farm’s portion of mortgage interest appears on Schedule F
Expense questions
• Are any expenses artificially inflated?
–
–
–
–
Charged to the farm but actually personal
Prepaid next year’s supplies during the current year
Two years’ of property taxes paid in one year
Big, out-of-the-ordinary repair bills
• Any expenses artificially low?
– Using up supplies purchased the year before
– Not fully accounting for labor cost
– Were all expenses actually paid?
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
I love doing taxes!!
Need good records to get accurate Schedule F
• Keep your recordkeeping system simple
• Use a system you can easily maintain
• Set up categories in your “chart of accounts” that
make sense to you in your operation
• Make sure your categories flow into Schedule F
categories
Feed
Hogs
Corn
Soybean meal
Mineral mix
Cattle
Corn
Hay
Salt and mineral
Choosing a recordkeeping system
Complexity of the farm operation
Level of detail wanted or needed
Employees and payroll?
Farmer’s comfort level in handling
recordkeeping
• Budget available for recordkeeping
•
•
•
•
What records should we keep?
• Farm income and expenses
• Sales and purchases of
capital assets separate from
normal income and expenses
• Accounts receivable and
payable
• Farm loans – principal
balances and interest
accrued or paid
• Inventories of raised products
and supplies on-hand
• Values of machinery,
buildings, other
improvements
Recordkeeping options
• Ledger book or handwritten records
–
–
–
–
Cheap and easy to use
Fine for small, less complex farms
Time consuming, won’t catch math errors
Generating data for analysis can be limited
• Computerized records (Excel or accounting software)
–
–
–
–
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Usually more expensive to purchase & update
Customizable to your operation, easier for analysis
Many reports available at the push of a button
Can be used on your farm or through an accounting service
Farm accounting software options
• QuickBooks
– Accounting Software for small businesses financial management
and bookkeeping.
– Customizable for agriculture
– Can be easy to learn, instruction & support readily available
– Available at office supply stores or at www.quickbooks.com
• CenterPoint (Red Wing)
–
–
–
–
Offers full set of financial reports for tax and business management
Ag-specific and adaptable to large and small operations
Training available
www.redwingsoftware.com
Farm accounting software options
• Easy Farm
– Offers farm record-keeping, crop & field tracking and livestock management
– Available through Technical College Farm Business instructors
– www.easyfarm.com
• AgManager
– Ag-specific accounting product
– Full scope of financial reports: payroll, resale inventory and managerial
accounting.
– Can be fully customizable to adapt to your operation.
– www.agrisolutions.com
• AAIMS
–
–
–
–
Ag-specific
Offers major financial statements and payroll
Available through UW Wisconsin Center for Dairy Profitability
cdp.wisc.edu/software.htm
• Low-cost or free cloud-based programs – FreshBooks, Wave, GnuCash
Recordkeeping options
• Accounting service
– Trained in accounting and payroll, and stay up-to-date on
current laws and regulations
– Resource for questions and business management
– Can be a “custom hire” service for records cleanup or
accounting processing
– Provides you with detailed, accurate accounting records
you can use to analyze your business
– Be sure your accountant understands agriculture
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Beginning to analyze Happy Farmer’s cash flow
What is “cash flow?”
The ability of the farm to generate enough cash to
cover all expenses and all loan payments when due,
pay for family living costs and any income taxes owed,
and still have some cash left for reinvestment in the
farm and to put something into savings.
Cash Flow and Profitability
• Related to each other, but very different
– Can have strong cash flow and be unprofitable
– Can be profitable with poor or negative cash flow
• Cash flow is absolutely critical!
• Profitability and cash flow are both important for
the farm to be economically sustainable
Happy Farmer’s cash flow the year they showed $44,312 Schedule F profit
Happy Farmer’s cash flow
• It’s positive for the year
• It wasn’t positive every month
• We don’t know if it is positive enough
– Is there enough extra cash to replace stuff that
rusts, rots, or wears out?
– Is there enough to adequately save for a rainy
day?
Now we need Happy Farmer’s balance sheet
What’s a 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)
at a point in time.
A balance sheet measures
the financial position of your farm.
What’s so great about a balance sheet?!
• Documents the value of your farm business assets
at a point in time…preferably January 1
• Summarizes all of your farm’s liabilities
• Shows progress you are making in the business
even if cash flow seems tight
• Aligns with your Schedule F, which makes financial
analysis easy
Three parts of a balance sheet
• Assets – Everything that is owned by or payable
to the farm on the date the balance sheet is
prepared
• Liabilities – All obligations owed by the farm on
the balance sheet date
• Owner’s Equity or Net Worth – Total assets minus
total liabilities
How farm balance sheets are different from
those of other businesses
• Assets usually listed at market value rather than
cost basis
• Categories for intermediate assets and liabilities
• Often difficult to separate farm assets from
personal assets
Key information from balance sheet
• Liquidity – Ability of the farm to meet its current
(short term) liabilities with current assets
• Solvency - Ability of the farm to pay off all of its
debts if it were to be sold tomorrow
8 more
buckets of
liquid assets!
Liquidity (current assets vs current liabilities)
• 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 assets vs current liabilities)
• 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 – All current assets minus all
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 = Net 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
Happy Farmer’s working capital 1/1/14
Happy Farmer’s net working capital is $5,913
Since annual gross revenue of the farm was $110,000, the net working capital
should be $16,500 (15% of annual gross revenue). We are short by $10,587.
We should plan to eliminate the deficit over four years from cash flow
$10,587 ÷ 4 years = $2,646 that needs to come from cash flow each year
Common liquidity problems
Working capital consists mainly of crop & feed
inventories and receivables, not much cash
(10-15% of a farm’s current assets should be held in cash)
Using up too much cash on capital purchases instead
of building working capital reserves
Operating losses carried forward year-to-year on credit
cards, lines of credit, open accounts
Poorly structured debt such as carrying capital
purchases on an operating loan
Large, unplanned expenses
Solvency ratios
• Debt to Asset: Total debt/total assets
– How much of the farm’s assets are owed to creditors?
– Should be less than 50%
• Equity to Asset: Equity/total assets
– How much of the farm’s assets are owned by the farmer?
– Should be more than 50%
• Debt to Equity: Total debt/equity
– How many dollars of debt does the farm have for each dollar
of the farmer’s equity?
– Should be less than 1.50. Less than .45 is a good long-term
goal.
Common solvency problems
Taking on term debt to cover years of negative cash flow
Too little cash flow after paying bills and making loan
payments to maintain buildings & equipment
Erosion in market values of assets
Big capital investments that don’t add much to the farm’s
market value
Assets depreciating faster than the loan balances are
being paid off
Your turn to do a balance sheet!
Balance sheet exercise
• Place all of the numbers in the right slots on
the balance sheet
• Calculate the current ratio
• Calculate working capital
• Calculate the debt-to-asset ratio
• Would you say this is a strong balance
sheet?
Balance sheet exercise
• Place all of the numbers in the right slots on
the balance sheet
• Calculate the current ratio 2.85
• Calculate working capital
$37,669
• Calculate the debt-to-asset ratio 38%
• Would you say this is a strong balance
sheet? Yes.
Now that we have a balance sheet,
we can finish analyzing Happy Farmer’s cash flow
Annual statement of cash flows
A year-end analysis of all cash that flowed into the
operation (including loan proceeds) and all cash that
flowed out (including family living expenses, taxes,
principal and interest payments).
Where did the farm’s cash come from? Was
there enough cash income to cover
operating expenses, income taxes, family
living costs, and loan payments? Was there
enough cash left to replace stuff that’s
rusting, rotting, or wearing out? Was there
cash available to build up working capital?
To analyze cash flow, we need to break it out
• 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
$10,000
Cash flow from operations
Vegetable sales
Farm operating expenses
Net cash from operations
$110,000
($ 52,850)
$ 57,150
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
Net change in cash
Ending cash balance
$0
($20,916)
$0
($30,000)
($50,916)
$ 6,234
$16,234
Key cash flow ratio
• Replacement Margin Coverage Ratio (RMCR) – All
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
Replacement Margin Coverage Ratio
RMCR should be
higher than 115%
Machinery $25,000 x 15% =
Bldgs $40,000 x 5% =
3,750
2,000
$5,750
Working capital deficiency
$2,646
Breakdown for Line 13: Principal and Interest payments
$250,000 mortgage, 5.5% interest, 20-yr amortization $20,916
Replacement Margin Coverage Ratio
RMCR should be
higher than 115%
Machinery $25,000 x 15% =
Bldgs $40,000 x 5% =
3,750
2,000
$5,750
Working capital deficiency
$2,646
Breakdown for Line 13: Principal and Interest payments
$250,000 mortgage, 5.5% interest, 20-yr amortization $20,916
With the Schedule F and the year’s beginning and
ending balance sheets, we can analyze profitability
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Profitability is calculated with an 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)
Profitability - The ability of the farm to generate an
adequate return on investment for your money, your
time, and your labor
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 income that shows up on Schedule F.
• 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, labor,
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 (yours and
lenders’).
GOAL: Higher than interest on borrowed money
• Rate of return on farm equity – The “interest rate” being
earned on YOUR portion of the investment in the farm.
GOAL: Higher than ROROA
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. Also includes
depreciation.
Income Statement
Income
GROSS FARM INCOME
$110,000
(Sch. F, line 9)
Expenses
Schedule F cash operating expenses
$52,850
(Sch. F expenses, excluding depreciation & interest)
Interest on farm loans
$7,838
(Sch. F line 21)
$60,688
TOTAL CASH FARM EXPENSE
Net CASH Farm Income
$60,688
$49,312
Changes in accrual categories+/(Jan. 1 2014 & 2015 balance sheets)
Total accrual adjustments +/- $ ----
-Economic depreciation
NET FARM INCOME
Economic depreciation (balance sheet)
Machinery $25,000 x 15% =
Buildings $40,000 x 5% =
$3,750
$2,000
$5,750
$43,562
Rate of Return on Assets
Net Farm Income
+ Farm interest
- Value of farmer’s labor
Return on farm assets
$ 43,562
$ 7,838
$ 30,000
$ 21,400
$21,400/$238,117 (avg farm assets) = 8.98%
ROROA should be higher than the interest rate on farm loans
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Rate of Return on Equity
Net Farm Income
- Value of farmer’s labor
Return on farm equity
$ 43,562
$ 30,000
$ 13,562
$13,562/$97,660 (avg farm net worth) =13.89%
Rate of Return on Equity should be higher than ROROA
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What about these “accrual adjustments?”
Example: If the Happy Farmer increased their credit
card balance from zero at the beginning of the year to
$6,000 by the end of the year (an increase in accounts
payable), we would need to adjust net farm income
down by $6,000.
Income Statement
Income
GROSS FARM INCOME
$110,000
(Sch. F, line 9)
Expenses
Schedule F cash operating expenses
$52,850
(Sch. F expenses minus depreciation & interest)
Interest on farm loans
$7,838
(Sch. F line 21)
$60,688
TOTAL CASH FARM EXPENSE
Net CASH Farm Income
$60,688
$49,312
Changes in accrual categories+/- Accounts payable +$6,000
(Jan. 1 2014 & 2015 balance sheets)
Total accrual adjustments
-$6,000
-Economic depreciation
$5,750
$37,562
NET FARM INCOME
Economic depreciation (balance sheet)
Machinery $25,000 x 15% =
Buildings $40,000 x 5% =
$3,750
$2,000
Rate of Return on Assets
after accrual adjustment
Net Farm Income
+ Farm interest
- Value of farmer’s labor
Return on farm assets
$ 37,562
$ 7,838
$ 30,000
$ 15,400
$15,400/$238,117 (avg farm assets) = 6.4%
ROROA should be higher than the interest rate on farm loans
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A few 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% Rate of Return on Assets
• Always do a January 1 balance sheet
• Don’t draw any big conclusions from one year’s financials
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Investment Analysis
Resources
• Three resources provided to us for free: sunshine;
wind; and precipitation
• Three resources we have available to invest: our
labor; our time; and our wealth
• Everything else can be borrowed, bought,
or rented
• Approximately 40 productive years
The big question: How do we make the
wisest use of all of the resources at our
disposal?
If we can develop cash flow projections for our
investment options, we can use Net Present
Value to analyze each option, and Internal Rate of
Return to compare one to another.
Time value of money
• The sooner you receive money, the better
– Money you get today can be invested or used to stop
interest from accruing
– Inflation causes money to lose buying power over time
• Benefit of investments are in the future
– The longer you have to wait for money to come in, the
less it is worth to you today
– We need to adjust values for the cost of waiting
– The longer you wait, the greater the risk that you won’t
get paid back
In Option A, we are “compounding”
In Option B, we are “discounting”
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Source: investopedia.com, Understanding the Time Value of Money
Net Present Value (NPV)
• Tells us what a future cash payment is worth in today’s dollars
• Converts a stream of future cash flows into a single current
value
• Can tell us if an opportunity is a good investment
• It won’t tell us if it’s our best investment of dollars
Scenario: Sunseed Farm’s D-10T potato digger
Sunseed Farm bought a new potato digger for $10,709.
Estimating that they made a 20% down payment and financed the
balance at 5% for 7 years, the payment on the digger is
approximately $1500/year. Net operating cash flow of growing
potatoes increased by $487/acre/year with the digger (some
operating expenses but much lower labor cost).
Without the digger, they could grow one acre of potatoes digging
them by hand. With the digger, they grew two acres in 2015, will
grow 4.5 acres in 2016, and at least 5 acres in future years. They
plan to use the digger for at least ten seasons. It should be worth
at least $3,000 at the end of the tenth season.
It is tempting to do this really simple calculation:
One year x $487 x 2 acres =
One year x $487 x 4.5 acres =
Eight years x $487 x 5 acres =
Salvage value
$974
$2,192
$19,480
$3,000
$25,646
Minus the initial down payment
Minus 7 years loan payments
=Net cash flow for 10 years
($2,142)
($10,500)
$13,004
This suggests you’d get a 607% return on your initial
investment ($13,004/$2,142 = 607%), which is NOT TRUE.
This calculation doesn’t consider the time value of money. To
consider the time value of money, we need to apply a discount
rate.
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How do we establish a “discount rate?”
• We could use the interest rate we would have to pay
to get a loan for the capital purchase
• We could use the prime lending rate and add to it the
rate of inflation
• We could set a personal “hurdle rate”…the least
return you’re willing to accept
• Whichever method we use, we need to adjust for the
riskiness of the investment. The more risky it is, the
greater the discount factor.
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Year
Annual Net Cash Flow
Discount Factor @
5%
Present Value of Annual
Net Cash Flow
1
($526)
.9523
($501)
2
$692
.9070
$628
3
$935
.8638
$808
4
$935
.8227
$769
5
$935
.7835
$733
6
$935
.7462
$698
7
$935
.7107
$664
8
$2435
.6768
$1648
9
$2435
.6446
$1570
10
$2435 + $3,000
.6139
$3337
Net Present Value of the cash flows
$10,354
Since the initial cash outlay was $2,142, it makes sense to make the investment.
But, if the return isn’t 607%, how much is it???
How good is the investment in the potato
digger?
(You can download this spreadsheet from:
http://www.badgerlandfinancial.com/en/Pages/Resources.aspx)
What about making a bigger
investment…like buying a farm?
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Another scenario: You have been renting a farm for
$12,000/year, saving up for a down payment, and hoping for
an opportunity to buy it.
The day has come; you can buy the farm for $250,000. You
will need to put down $75,000 and finance $175,000 on a
20-year note at 5% interest = $14,042/year payment
You’ve developed a cash flow projection. With loan payments,
property taxes, and annual building repairs & improvements,
your cash outlay will be $10,000 more each year owning the
farm compared to renting it. However, you will be building
equity and expect the farm’s market value to increase by 4%
each year.
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You really want to buy this farm BUT is it a good investment?
Factors to consider
• Cash outlay is $75,000
• Net annual cash flow is estimated to be ($10,000)
compared to continuing to rent the farm
• Farm should be worth approximately $304,000 in five years
• Mortgage balance in five years will be approximately
$145,000
• Owner’s equity in five years will be $159,000 minus
“contingent liabilities,” an estimate of sales costs that
would have to be paid if the farm was sold
– $304,000 x 8% = $24,000
– $159,000 - $24,000 = $135,000 estimated owner’s equity
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Does it make financial sense to buy the
farm?
We can use our Net Present Value and Internal Rate of
Return tools to analyze the investment
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NPV of cash flows for the farm
Year
Annual Net Cash Flow
Discount Factor
@ 5%
Present Value of
Annual Net Cash Flow
1
($10,000)
.9524
($9524)
2
($10,000)
.9070
($9070)
3
($10,000)
.8638
($8638)
4
($10,000)
.8227
($8227)
5
($10,000) + $135,000
.7835
$97,938
Net Present Value of the cash flows
$62,479
Since the initial cash outlay was $75,000, this is NOT a good investment.
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How “not good” is the investment?
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Some cautions
• This is only the beginning, not the whole story
• There can be good reasons to make a capital investment
even if the NPV/IRR calculation doesn’t support it
• Don’t substitute enterprise budgeting or investment analysis
for whole farm financial planning
• Month-by-month cash flow projections are extremely
important if you are relying on income from your farm to
support family living costs
• People become farmers for many different reasons; high
profitability is not usually #1. And that’s okay!
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