analyzing business opportunities ray massey commercial ag program
TRANSCRIPT
Reasons businesses fail
• Insufficient liquidity – not enough cash to meet obligations when they come due.
• Insufficient solvency – not enough assets to pay off debts.
• Insufficient profitability – not enough revenue to cover expenses.
Balance Sheet
• Date is critical• Snapshot of the financial health of a business
at a point in time• Provides information regarding questions of
net worth, debt and assets
Balance Sheet
Beginning Balance Sheet Ending Balance Sheet
Asset Asset
Liability Liability
Equity Equity
Profit
Financial Feat: Increasing Net Worth
Gross IncomeExpensesNet IncomeFamily WithdrawalsChange in Net Worth
Balance Sheet
Beginning Balance Sheet Ending Balance Sheet
Income Statement
Revenue
- Expense
Net Income
AssetAsset
LiabilityLiability
EquityEquity
Income Statement
• Looking at a period of time (1 year)• Important to distinguish between
– cash inflow and outflow – Income and expenses
• Helps manage production, finance and marketing
• Provides information on productivity
Financial Statements
• Aid in tracking progress toward goals• Provide information for making decisions
which promote achieving goals
Ratio Analysis
• Return on assets– ROA = (Net income + Interest) / Total Assets
• Return on Equity– ROE = Net income / Total Equity
• Leverage – the relationship between ROA and ROE
Relationship Between ROA & ROE
Return on Assets
Return on Equity D/A = .5; i = 10%
D/A = 0.15
.10
.05
-.05
-.10
-.15
-.15 -.10 -.05 .05 .10 .15
Fixed and Variable Costs
• Fixed Costs - those not affected by how much an asset is used.
• Variable Costs - those which are proportional to how much an asset is used.
Fixed Costs
• Cost per unit of output decreases as quatity of output increases
• DIRTI 5– Depreciation– Interest– Repairs– Taxes– Insurance
Variable Costs
• Cost per unit of output remains constant with the quantity of output.
• Examples– Feed– Veterinary and Medicine– Fuel– Labor
Which of the following costs are fixed and which are variable?
• Purchased Feed• Repair on Equipment• Maintenance of Buildings• Bull Purchase• Vaccinations
Cash and Non-cash Costs
• Cash Costs - costs incurred when inputs are purchased for production
• Examples– Wages– Purchased Feed– Fuel– Supplies
Cash and Non-cash Costs
• Non-cash Costs - implicit costs which do not require a present outlay of cash when the input is used.
• Examples– Unpaid Family Labor– Interest on Owner’s Equity– Depreciation
Sunk Cost
• A cost which has been incurred already.• A sunk cost can be fixed or variable
– Depreciation is a fixed sunk cost– Feed is a variable sunk cost once the feed has
been fed.
Necessary and Postponable Costs
• Necessary Costs - costs associated with essential functions
• Postponable Costs - costs which are critical but which may be postponed for a period in order to save a current cash outlay.
Which of the following costs are necessary and which are postponable?
• Purchased Feed• Repair on Equipment• Maintenance of Buildings• Bull Purchase• Vaccinations
Partial Budgeting
• Additions
– Added Returns
– Reduced Costs
• Subtractions
– Added Costs
– Reduced Returns
Partial Budgeting Examples
• Expanding or Contracting Herd Size• Purchasing or Leasing Equipment• Renting or Purchasing Additional Land• Changing Technology
– Organic vs conventional production– Compost vs fresh manure production
Partial Budgeting and Liquidity
• Depreciation is no longer an added cost• Interest is cash interest rather than an
opportunity cost of interest• Determine ability to make loan payments
Partial Budgets and Risk
• Look at the worst case scenario• Consider interaction with other enterprises
– Labor Demands– Equipment Demands
• Long run or Short run Perspective– Prices– Life of Assets
Risk
• “I have seen something else under the sun: The race is not to the swift or the battle to the strong, nor does food come to the wise or wealth to the brilliant or favor to the learned; but time and chance happen to them all.”
Ecclesiates 9:11
Sources of Risk
• Production Risk – risk associated with having less than anticipated yield
• Price Risk – risk associated with having less than a target price
• Financial Risk – risk associated with having insufficient cash flow
• Legal Risk – risk of liability• Human Risk – risk associated with
human/employee judgement
Economic Principle: Risk Return Tradeoff
• Higher returns accompany higher risks• Manage Risk - do not avoid risk• Manage risk by
– Gathering pertinent information– Taking safe decisions – livestock futures– Paying someone else to take the risk from you –
livestock options and other insurance
Analyzing Decisions Accounting for Risk
• Define the possible states of nature– Calving percent of 70%, 80%, 90%– Drought: yields = 1 ton hay, 2 tons, 5 tons
• Determine different actions to take– Stocking rate– Herd health
• Estimate outcomes associated with different actions given different states of nature.
• Make a choice
Decision Making Criteria
• choose action with highest expected return– ignore risk– weighted for probability of outcomes
• mean-variance analysis - choose action a, if returna > returnb and variancea < varianceb,.
• Safety first (or maximin) – choose action with highest minimum outcome
• Shoot for the Moon (maximax) – choose action with highest maximum outcome
Stock moderately
State High rainfall Average rainfall Low rainfall
Receipts $95,630 $95,075 $92,625
Expenses
cattle 84000 84000 84000
forage 2900
supplement 600
interest 3000 3000 3000
veterinary 430 430 800
miscellaneous 200 145 325
Total expenses 87630 87575 91625
Return to land, operator labor, management and capital
8000 7500 1000
Stocking Rate Example
Stocking Rate ExampleDecision
State Stock lightly Stock moderately
Stock heavily
Probability
high rainfall 5000 8000 14,000 .3
average rainfall 4500 7500 6,000 .6
Low rainfall 4000 1000 -5,000 .1
Stocking Rate DecisionDecision
State Stock lightly Stock moderately
Stock heavily
Probability
high rainfall 5000 8000 14,000 .3
average rainfall 4500 7500 6,000 .6
Low rainfall 4000 1000 -5,000 .1
Average 4500 5500 5000
Weighted average
4600 7000 7300
Keys to Decision Making
• Major on the major• Gather pertinent information• Make a decision or plan• Write out the plan• Have someone keep you accountable to the
plan
Sources of Risk: Production Risk
• Select low production risk enterprises• Diversify business• Maintain cost flexibility• Use risk-reducing production practices• Invest in extra machine capacity• Diversify farm operation geographically• Negotiate land lease arrangements• Maintain resource reserves• Purchase crop insurance• Obtain additional information
Sources of Risk: Market Risk
• Hedge on futures market• Insure using options market• Sell by forward contracts• Spread product sales over time• Maintain product and harvest cost flexibility• Select low-price risk enterprises• Diversify business• Negotiate land lease arrangements• Forward price production inputs• Obtain more outlook information
Sources of Risk: Financial Risk
• Keep adequate liquidity• Maintain credit reserve• Negotiate longer loan repayment periods• Hold safe solvency position• Develop land leasing strategies• Incorporate to limit risk• Obtain more accounting information
Sources of Risk:
• Technology Risk– Maintain flexibility– Keep informed of new developments– Lease rapidly changing technology
• Legal Risk– Maintain insurance program– Keep informed on new regulations– Hire custom and contract work