Extension Circular 375 FarmBusinessAnalysis:

Key toPennsylvaniaFarmProfitability

College of Agricultural SciencesCooperative Extension

Introduction 3

Part I: Types, methods, andframework for analysis 4

Types of analysis 4Methods of analysis 4Comparative 4Ratio 4Projected 4A conceptual framework foranalysis 4

Part II: Tools of farmbusiness analysis 6

Budgets 6Balance sheets 8Assets 8Liabilities 8Networth 8Balance sheet analysis 8Income statement 10Farm operating receipts 11Farm operating expenses 11Adjustments 11Net farm income 11Income statementanalysis 11Cash flow 12Analysis of cash flow 14

Part III: Using informationfrom the farm businessanalysis 18

Signs of pending financialdifficulties 18Specific solutions for severefinancial problems 19

Summary 21

Contents

Figures

1. Dairy cow budget 62. Farm balance sheet 103. Farm incomestatement 134. Annual cash flow 155. Monthly cash flow 16

Good farm records are thefoundation of good farmmanagement. When farmrecords can be used by farmmanagers to quickly analyzesituations and reach deci-sions, they are powerful toolsto use in enhancement offarm profitability.

The first step in this processis the establishment andmaintenance of farm businessrecords. But this is notenough. Records that aredeveloped, but not under-stood or not used, make nocontribution to the decisionmaking process that isessential to successful farmmanagement.

Farm business analysis—theprocess of retrieving, organiz-ing, processing, and analyzinginformation used in farmbusiness decision making—isa critical ingredient in themanagement of the modernfarm. Managers must be ableto quickly respond to changesin the prices of the inputsthey buy and the productsthey sell if they are tomaintain farm profitability intoday’s rapidly changingmarketplace. Producers areno longer isolated fromchanges elsewhere in theeconomic system. They mustsuccessfully respond tochanges in consumer tastes,government regulations, anda whole host of otherchanges that occur in theworld beyond the farm gate.

Detailed and accurateinformation is a necessarycomponent of the farmmanager’s decision makingprocess. This is why goodfarm records are the founda-tion of good farm manage-ment.

The farm manager must beable to use business recordsin day-to-day decisionmaking. Use of farm businessrecords in managementrequires ability to organizeinformation from the records,to select the relevant fromthat which is less important,and to focus on the areas ofthe business that needattention. (See ExtensionCircular 359, “Maintainingand Using Farm Records,” fora detailed discussion of farmrecord keeping).

This publication providesinformation that managerswill find helpful as theyapproach the task of usingtheir farm records in makingbusiness decisions. The firstsection is devoted to a reviewof the types and methods ofanalysis and a conceptualframework of the analysisprocess. The second part ofthe publication considerssome tools of analysis thatare available to the farmmanager who has maintainedan adequate set of farmrecords and who wants to usethose records in businessanalysis. Part three discussesthe use of information fromthe farm business analysis.

Introduction

3

Types of Analysis

Farm business analysis mayinvolve either the whole-farm or a single enterprise.Whole-farm analysis considersbusiness features that affectthe entire business. Itincludes balance sheetanalysis which shows changesin total assets, liabilities andresulting net worth; incomestatement analysis whichshows changes in businessreceipts, expenses, andvarious accounting adjust-ments; business cash flowanalysis which indicates theamount of funds entering andleaving the business; andratio analysis which canreflect what is happening inthe entire business.

Only a part of the business,typically a single enterprise,is considered in an enterpriseanalysis. A study may bemade of the dairy enterpriseon a farm that includes adairy herd, crops, and ahorticultural enterprise. Asingle crop enterprise, such asalfalfa, may be the item ofinterest even though it isproduced on a farm that alsoproduces hogs and corn.Usually, more attention isgiven to specific items of costof production when complet-ing an enterprise analysis.Comparisons with othersimilar enterprises aretypically a part of this kind ofanalysis.

Methods of Analysis

Several methods are avail-able in completing a farmbusiness analysis. Theseinclude comparative analysis,ratio analysis, and projectedanalysis.

Comparative AnalysisComparative analysis can beused for single farm compari-son to compare performanceof a particular farm businessor an enterprise from a farmthrough time (for example,comparison of performancein Years 1, 2, 3). It can alsobe used for multi-farmcomparison of one farm unitor enterprise with anotherfarm unit or enterprise.Multi-farm comparison haslimits because it is difficult tofind comparable businessunits. For multi-farmcomparison to be valid, itmust be restricted to farmunits that use similartechnology and operateunder similar conditions. Forexample, comparisonsbetween Southeast Pennsyl-vania and North-CentralPennsylvania farms or farmenterprises can be verydifficult to accuratelyinterpret because of thedifferent climatic and soilconditions that exist in thosetwo areas.

Ratio AnalysisRatio analysis is used largelyin whole-farm analysis. This

process involves computingratios from farm businessdocuments, such as thebalance sheet, and comparingthe computed ratio withestablished standards. Thesestandards are not always welldefined in terms of thespecific values that indicatestrength or weakness.Variations in farm businessesbetween regions and differ-ences related to the type ofenterprises also are a handi-cap. However, this methodcan be used as an earlyindicator of the condition ofa business. That preliminarycondition then must beconfirmed with a thoroughstudy of the particular farmunit for which the analysis isbeing completed.

Projected AnalysisProjected analysis is usedmost frequently for cash flowand income statementanalysis, but may also be usedwith other farm financialdocuments such as thebalance sheet. The goal ofthe projected analysisdepends on the documentbeing projected. For example,the projected cash flowestimates cash receipts,expenses, and cash balancefor a future period. Aprojected income statement(also known as a pro-formaincome statement) indicatescash receipts and expenses aswell as the projected ac-counting adjustments thatconvert cash measures into

projected earnings for theperiod (net farm income). Aprojected balance sheetestimates changes in assetsand liabilities and increasesor decreases in operator’s networth over the periodprojected.

A projected analysis isdependent on developmentof enterprise and farmbudgets. (A budget is anestimate of sources of incomeand amount of costs). Thebudgets provide informationfor the projection of income,expense, net income, andamounts of resources used.

A Conceptual Frame-work for Analysis

The process encompassed inthe term “farm businessanalysis” can be conceptual-ized in three questions. Theseare:

■ Where are we?■ Where do we want to be?■ How do we get there?

These questions indicate thata business analysis beginswith a review of currentconditions – the resourcesavailable to the business, thecurrent operating plan, theexisting financial condition,and the skills and manage-ment ability of the operator.

Goals are a part of theprocess, perhaps best thought

4

Part I: Types, Methods, and Framework for Analysis

of as the end result of theanalysis procedure. Acomparison of goals andcurrent position will indicatethe changes needed to movethe business from the currentposition to the position itwill occupy at some futuredate.

Planning based on analysis ofthe business unit provides theanswer to the final question.A business will progresstoward a goal only if plansare developed that can moveit from where it is to wherethe operator wants it to be.

The analysis process shouldbegin with consideration ofthe business as a whole.What are the strengths andweaknesses of the unit?What is the financialcondition as evidenced bythe balance sheet and areview of net worth? Howmuch debt is there? Is thedebt manageable given therequirements for obligationssuch as taxes, family livingexpenditures, and businessexpansion? Does the incomestatement indicate that thebusiness is profitable? Areresources (land, labor,capital) efficiently used bythe business?

In considering the abovequestions, one shouldconsider a number of factors.The land resource is expen-sive and scarce and shouldreceive special attention inthe analysis process. Thedegree to which land is usedfor appropriate high-profitcrops (corn, alfalfa, soybeans)is an indicator of efficiencyin land use. Other indicatorsare crop yield per acre andvalue of total farm produc-tion per acre.

Labor must be used effi-ciently if the farm business is

to succeed. Various criteriaare available for evaluatinglabor efficiency. Some of thebetter criteria are value ofproduction per worker,quantity of product (poundsof milk sold per worker), andnumber of productive workunits used on a specific farm.

Efficiency in use of capital isincreasingly importantbecause of the long-termupward trend in interestrates. Rate of return oninvestment and rate ofcapital turnover are the mostoften used measures ofefficiency in use of capital. Arate of return on investmentequal to current interest ratesis a desirable goal, but rarelyobtained on most operatingfarms. A practical goal forrate of return is one equal toor greater than the long-termaverage rate of return onfarm assets. This long-termrate has averaged about sixpercent over the past severaldecades.

Rate of capital turnover iscomputed by dividing valueof farm production by totalcapital investment. Rate ofcapital turnover realized ondifferent farms depends onthe major enterprisesproduced. Poultry operationshave a very rapid rate ofcapital turnover (more thanonce per year in some cases)while beef cow-calf opera-tions usually experience alow rate, requiring severalyears for a complete turnoverof capital. Dairy operationshave an intermediate rate,their capital turnover usuallyrequiring about three years.

Sufficient volume of businessis a key to farm businesssuccess and should beconsidered early in theanalysis process. A farm mustgenerate enough total dollars

to meet needs for taxes,insurance, debt repayment,business expansion, andfamily living, after paymentof cash operating expense.Typically, 70 percent to 80percent of gross receipts arerequired for cash expenses.Thus, 20 to 30 percent ofgross receipts are all thatremain to cover fixedobligations and family living.

A quick estimate of requiredbusiness gross receipts can becalculated by multiplying thesum of fixed obligations andfamily living needs by four orfive. For example, if theoperating margin (cashreceipts minus operatingexpenses) is 20 percent, theoperator must sell $5 in farmproduct in order to have $1for family living expenses.

Once an analysis of thewhole business is completed,it is helpful to become morespecific and consider individ-ual enterprises. Yields,amount of inputs used, andcosts of production becomeimportant criteria for analysiswhen considering a specificenterprise. In evaluating analfalfa crop, for example, thefarm manager should beconcerned with tons of forageproduced, feeding quality,the costs of producing thecrop, sale price, and netincome. With the dairyenterprise, pounds of milkproduced, inputs used (feed,labor) and their cost, andincome above cash costs areimportant analysis criteria.

The balance sheet and theincome statement provideinformation about thecondition of the business as awhole. Net worth and netfarm income are factors thatcan be used to quicklyevaluate the business.Certain ratios discussed in

the next section can becalculated from the balancesheet and help to evaluaterelative strength or weakness.

5

Figure 1. Dairy Cow Budget for 17,000 Pounds of Milk and Replacements using 50 Percent Concentrate and 50 Percent Forage.

Item Rate Amount Unit $Value $Total

Income

Milk sales $1 170 cwt 13.50 2,295.00

Cows culled $0.29 13 cwt 47.00 177.19

Calves sold $0.44 1 cwt 100.00 144.00

Gross Income 2,516.19

Variable costs

Feed costs

Corn grain equivalent $2.30 126 bu 289.80 289.80

Soybean equivalent

Hay equivalent $90.00 5.4 ton 486.00 486.00

Corn silage (as fed) $20.00 8.9 ton 178.00 178.00

Soybean meal $16.80 14.9 cwt 250.32

Dicalcium phosphate $0.07 101 lb 7.07

Limestone $0.03 30 lb 0.90

Salt $0.07 91 lb 6.37

Supplemental feed cost 264.66

Other feed purchases

Total feed cost 1,218.46

The tools of business analysisare composed of the financialrecords maintained for a farmbusiness and the variousdocuments that are devel-oped from those records.Included in the list arebudgets, the balance sheet,the income statement (profitand loss statement), and thecash flow summary.

Budgets

A budget is an estimate of therevenue, costs, and netincome of a farm unit or anenterprise. Development of a

budget helps the farmmanager to organize informa-tion into a logical order.Income and expense itemsotherwise overlooked areoften exposed throughdevelopment of a budget.

The budgeting process isextremely helpful whenvisiting a lender, bothbecause of the informationavailable from budgets anddue to the “business-like”image created for the personwho offers budgets to supporta loan request. Lenders havemore confidence in aprospective borrower who

organizes and plans—bothcharacteristics are reflectedin a budget.

Budgeting is a basic farmbusiness analysis procedure.Budget information is used inprojections of cash flow,profit or loss, and the balancesheet. Cash flow projectionsbased on budgets are moreaccurate and can offer moredetail than those using lastyear’s figures or strictlyestimates. The projectedincome statement andbalance sheet require budgetinformation to accuratelyreflect the best estimates of

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Part II: Tools of Farm Business Analysis

business earnings andchanges in owner equity.

Figure 1 is an example of anenterprise budget. Thebudget provides detailedlistings of sources andamount of income andexpenses. It indicates theamount of inputs required forthe enterprise, such asquantities of grain, silage,hay, and other feed compo-nents. Costs are divided intovariable (cash) costs andfixed (overhead) costs.Finally, the budget reflectsreturns above both variableand total costs.

continued on next page

Item Rate Amount Unit $Value $Total

Other variable costs

Building repairs 10.50 10.50

Equipment repairs 12.00 12.00

Bedding 40.00 40.00

Misc. livestock supplies 72.00 72.00

Breeding fees 36.00 36.00

Vet. & medicine 58.70 58.70

Milk testing 15.00 15.00

Gasoline, fuel, oil 10.60 10.60

Utilities 60.50 60.50

Insurance 10.00 10.00

Interest on operating capital 63.37 63.37

Coop dues (milk) 170 cwt 0.15 25.50

Milk hauling, freight 170 cwt 0.65 110.50

Marketing 170 cwt 0.12 20.40

Other cash costs 14.00 14.00

Advertising 170 cwt 0.05 8.50

Family labor

Hired labor $5.00 25 hr 125.00 125.00

Total of other costs 692.57

Total variable costs 1,911.03

Fixed costs per cow or per unit

Interest on cow and rep 10% 1,050 138.85

Equipment depreciation 10% 800 80.0

Building depreciation 10% 1,800 180.00

Management charge 5% 125.81

Total fixed costs 524.66

Total costs per cow or per unit 2,435.68

Returns above variable costs 605.17

Returns above total costs 80.51

Cost per cwt milk

Gross income 14.80

Feed costs 7.17

Total variable costs 11.24

Total costs 14.33

7

Figure 1. continued

Balance Sheets

Different names are used todescribe the document herecalled a “balance sheet”. It isoften called a financialstatement and sometimes anet worth statement. The term“balance sheet” implies somekind of balance as part of thedocument. The balancerelates to the relationshipbetween assets on one side ofthe document and liabilitieson the other side. Thatbalance results in the basicaccounting equation whichstates that assets always equalliabilities plus owner equity.

Balance sheets may reflectboth business and personalassets and liabilities or onlybusiness or only personalassets and liabilities. If bothbusiness and personal assetsand liabilities are included,the result is a consolidatedbalance sheet. If onlybusiness assets and liabilitiesare included, the documentis a business balance sheet. Ifthe document includes onlypersonal assets and liabilities,it is a personal balance sheet.

The balance sheet provides a“snapshot” of a business’financial position at aspecific point in time. It isone of the most basic toolsused in financial manage-ment and should be devel-oped on an annual basis byevery farm manager. Bycomparing end-of-yearbalance sheets from consecu-tive years, the manager candetermine changes that areoccurring in the various typesof assets and liabilities.Changes in net worth,through time, can also bedetermined by comparison ofbalance sheets from severalyears.

composed of current,intermediate, and long-termobligations.

Current liabilities are thosewhich impact the businesswithin one year. Theyinclude bills or accounts duewithin one year. Income tax,FICA or self-employmenttax, real-estate tax, and notesare included in this category.Principal payments onlonger-term debts andinterest due within one yearare also part of currentliabilities.

Intermediate-term liabilities arethose items which areexpected to impact thebusiness after one year butwithin ten years. Theyinclude debts due after oneyear but within ten years.Loans used to purchasemachinery or equipment andbreeding livestock are usuallyclassified as intermediate.

Long-term liabilities are relatedto real estate and typicallyinvolve debts due after morethan ten years from theinitial date of the loan. Realestate mortgages are thetypical obligation thatappears on the balance sheetas a long-run liability.

Net WorthNet worth is computed bysubtracting total liabilitiesfrom total assets. Net worthreflects a position at a pointin time and will differ day today or year to year.

There is no standard form forthe balance sheet. However,there is a degree of uniform-ity among these documents.Regardless of the source, abalance sheet will includecurrent assets and liabilities,intermediate assets andliabilities, long-term assetsand liabilities, and net worth.

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AssetsA number of definitions arein order before proceedingwith a discussion of using thebalance sheet in farmbusiness analysis. An asset issomething having economicvalue that is controlled by anindividual or firm. Assetsinclude cash, personalproperty convertible to cashgiven sufficient time, andreal estate. The length oftime required to change theitem to cash determines thetype of asset. The types ofassets are current, intermedi-ate, and long-term.

Current assets are thosewhich impact the businesswithin one year. Currentassets include cash, accountsor securities easily convertedto cash, and commoditiesthat will produce cash withintwelve months. Inventoryitems (feed, fertilizer, fuel)and livestock raised for saleare current assets. (SeeExtension Circular 359,“Maintaining and UsingFarm Records,” for a morecomplete discussion ofinventories).

Intermediate-term assets arethose items which areexpected to impact thebusiness after one year butwithin ten years. Thiscategory includes assets usedin production of income.Machinery and equipment,breeding livestock, retire-ment accounts, and longer-term securities are classifiedas intermediate assets.

Long-term assets are primarilyrelated to real estate. Landand improvements are theusual long-term assets.

LiabilitiesLiabilities are the financialobligations incurred by anindividual or firm. They are

Balance Sheet Analysis

The balance sheet provides across-section view of thefinancial side of a business. Areview of the balance sheetprovides insight into thefinancial health of thebusiness. Comparison ofbalance sheets from abusiness through timeprovides a general indicationof performance of thebusiness.

The balance sheet analysisshould begin with a compari-son of total assets andliabilities. The difference isnet worth. If total assetsexceed total liabilities, thebusiness is solvent and networth is positive. Whenliabilities exceed assets, thebusiness is insolvent and networth is negative.

The net worth of a businesson a given date indicatesowner equity and is a verygeneral indicator to a lenderof the risk involved inmaking a loan. If net worth islarge relative to total assetsin the business, the loan canbe well secured and thechance of loss is small. Asmaller net worth maypresent an obstacle tosecuring credit because risk ofloss to the lender is greater.

A comparison of currentassets and current liabilitiesfrom the balance sheetindicates ability of thebusiness to meet cashobligations as they come due.A business that is able tomeet its current cashobligations as they come duepossesses liquidity.

The balance sheet of abusiness in a healthy finan-cial condition will reflect anexcess of current assets over

current liabilities. Typically,that excess should be one-and-one-half to twice asmuch in current assets as incurrent liabilities. The excessis needed for several reasons.

A first reason is to serve as afinancial cushion in case ofrapid change in price of theproperty making up thecurrent assets. A rapid dropin price will destroy theliquidity of a business thathas barely enough currentassets to cover currentliabilities.

A second reason that excesscurrent assets indicates goodfinancial health is that thisexcess is the source ofworking capital for thebusiness. Working capital isthe source of funds forcurrent operating expense—the items that must bepurchased on a day-to-dayschedule to keep the businessoperating. If there is adeficiency of working capital,the business must borrowadditional funds or it mustliquidate intermediate assetsto secure working capital.The procurement of addi-tional credit often takes time.If intermediate assets areliquidated, the assets thatproduce income for thebusiness have been removedand future income flow willbe reduced. Thus, assetliquidation is not a viablelong-term alternative.

A number of ratios havebeen developed to help inreview of the balance sheet.These should be consideredas useful tools for initialevaluation of the documentbut not as the final answer tothe question ‘what is theproblem in the business’?They are general indicatorspointing to a need for furtherstudy.

will have a net capital ratioof approximately 2.5 or more.This means that ownerequity is 60 percent or moreof the total assets used in thebusiness.

The debt-equity ratio is asecond measure of businesssolvency. The debt-equityratio reflects the relationshipbetween borrowed and equity(or owned) capital used inthe business. It is computedby dividing total debt byowner equity. Lenders oftenrefer to this ratio becausethey prefer to make loans tothat borrower who has anequity of 50 percent or moreof total assets used in abusiness. Thus, lenders prefera debt-equity ratio of lessthan one. This indicates thatthe owners contribution ismore than that of the lender.

A financially healthybusiness will generally have adebt-equity ratio of .67 orless. However, this can varydepending on the quality ofmanagement, the enterprisesthat are the source ofincome, and the level ofprofits. Perhaps the mostvaluable feature of thismeasure of solvency is thetrend value—that is, thechanges that occur to theratio through time. If theratio deteriorates throughtime—that is, it increases inabsolute size, there is reasonfor concern and a carefulreview of the farm businessshould be undertaken. Arising debt-equity ratiomeans that debt is increasing.

Figure 2 is a typical farmbalance sheet. Current,intermediate, and long-termassets are itemized on the lefthalf of the page and similarcategories of liabilities arearranged on the right half ofthe page. Current assets and

liabilities (and other catego-ries) are arranged on oppositesides to facilitate comparison.For example, current assetson this balance sheet total$301,025 and currentliabilities are $59,232.

Various balance sheetanalysis criteria discussedabove can be illustrated withFigure 2. For example,solvency can be determinedby comparing total assets andtotal liabilities. Total assetsof $1,207,771 exceed totalliabilities of $466,592; so thebusiness is solvent. Thedifference between assets andliabilities is net worth—asecond criteria for analysis ofthe balance sheet. Net worthin this case is $741,179.

Net capital ratio computedfrom Figure 2 is 2.59($1,207,771/$466,592). Thisindicates good financialhealth for the businessrepresented by Figure 2. Thedebt-equity ratio is .63($466,592/$741,179). Thisindicates there is 63 cents ofdebt for each dollar ofequity—the operator ownssomewhat more of thebusiness than the lender.This also indicates a healthyfinancial condition.

Liquidity is measured bycomparing current assetswith current liabilities. Figure2 indicates a large surplus ofcurrent assets over currentliabilities—thus a highdegree of liquidity for thisbusiness and an adequatesupply of working capital.The current ratio providesmuch the same relationshipin ratio form. The currentratio for this business is 5.08($301,025/$59,232), which iswell above the level consid-ered necessary for goodfinancial health.

The debt structure ratio (orcurrent debt ratio) measurescurrent liabilities relative tototal liabilities. It is calcu-lated as follows:

Debt structure ratio Current liabilities Total liabilities

The debt structure ratioindicates the part of totaldebt that must be repaidwithin one year. A ratio of1:4 (or .25) indicates that 25percent of total debt must berepaid within one year. Thehigher the ratio, the greaterwill be the drain on cashreserves and the more therisk of being unable to repaycurrent debt obligations ontime. A high ratio of currentto total liabilities mayindicate a need to refinance.The refinancing processtypically converts part of theshort-term debt to a longer-term obligation.

The debt structure ratioshould be interpreted withcare. It probably should beused only in association withother analysis variables to putit into perspective. Forexample, an individual with$500,000 net worth and$3,000 of liabilities, com-posed of $2,000 currentliabilities and $1,000intermediate-term liabilities,has a debt structure ratio of2:3 (.667) but is in noimmediate danger of finan-cial distress.

The net capital ratio is acommon measure of sol-vency. The net capital ratiois total assets divided by totalliabilities. A business issolvent if the ratio is morethan one—that is, there ismore than one dollar ofassets for each dollar ofliabilities. However, afinancially healthy business

=

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Figure 2. Farm Balance Sheet

Farm Balance Sheet (Statement of Assets and Liabilities)

X Estimated market value Cost less depreciation

Date, January, 1988

Assets

Current $

Cash on hand and in bank 2,000

Notes & accounts receivable 11,940

Market livestock 92,420

Crops & produce for sale

Feed & farm supplies 149,065

Growing crops 1,600

Other (marketable securities) 40,500

Cash surrender value - life insurance

Savings 3,500

Total current 301,025

Intermediate

Breeding livestock 154,430

Machinery & equipment 85,321

Other

Depreciable property 25,073

Total intermediate 264,824

Fixed

Land and buildings

Land 460,500

Depreciable property 143,422

Dwelling 38,000

Total fixed assets 641,922

Total assets 1,207,771

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Income Statement

The income statement is theonly tool of farm businessanalysis that measuresprofitability. Budgets, thebalance sheet, and the cashflow projection are valuableand essential managementtools, but they do not tell themanager if the business isprofitable.

The income statementmeasures business earningsresulting from businessoperation as opposed to

business ownership. Whileappreciation in value ofbusiness assets may increaseowner net worth, that sourceof funds is available only ifthe business is liquidated. Incontrast, the earningsreflected on the incomestatement are the result ofoperations. Those amountsmay be used for currentexpenditures or as anaddition to owner equity.

The income statement canbe computed monthly,quarterly, semi-annually,annually, or on some other

Liabilities & equity

Current $

Accounts payable

Bank operating loans

Intermediate debt due this year 11,375

Long term debt due this year 3,938

Other

Interest-intermediate loans 12,602

Interest-long term loans 31,317

Total current 59,232

Intermediate (due in 1 to 10 years)

Term notes (less current portion)

PCA 48,133

PA National 50,000

Total intermediate 98,133

Long term (over 10 years)

Term notes & mortgages (less current portion)

Land Bank 309,227

Total long term 309,227

Total liabilities 466,592

Net worth 741,179

schedule depending on whatis needed for managementpurposes. Most farm busi-nesses use an annual incomestatement. The annualstatement is consistent withthe production cycle forlivestock and crop enterprisesand with calendar yearrecord-keeping and tax filingactivities. This approachpermits comparison of farmprofitability from onecalendar year with profitsfrom prior and subsequentyears.

Three major sections in theincome statement arereceipts, expenses, andadjustments. The receiptsand expenses section reflectcash flow during the year.The adjustments are neces-sary to convert cash flow toannual earnings by includinginventory change, accountspayable and receivable, anddepreciation. Consolidatedincome statements alsoinclude nonfarm income andfamily withdrawals incalculations.

not deducted in computingnet farm income, thenexpenditures for family livinghave a priority claim on partof the amount reflected innet farm income.

Interpretation of net farmincome requires goodjudgement on the part of theevaluator. More is generallybetter, but evaluation of thelevel of net farm incomefrom a particular farm mustbe completed with a view totype and size of operation. A$7,500 net farm income froma 60-cow beef herd mightreflect an excellent return.But that level of net farmincome from a 60-cow dairyherd is unacceptable, basedon recent rates of return forsuccessful dairy operations.Thus, it is necessary to havestandards for comparison inevaluating net farm income.

The standards needed inevaluating net farm incomeare available for some farmtypes and enterprises, but notavailable for others. InPennsylvania, very goodinformation is availableabout dairy farms; other farmtypes are more difficult toevaluate. Regional differ-ences do exist and theevaluator should be carefulthat the standard being usedis the appropriate one for thelocation of the farm underconsideration.

The operating ratio is anothervariable that can be used toevaluate net farm income.The operating ratio is totaloperating expense (cash farmexpense) divided by grossincome. The ratio convertedto a percentage reflects thepart of gross income that isrequired to cover farmoperating expense.

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Farm Operating ReceiptsFarm operating receipts arethe first group of items on theincome statement. Thisgroup includes cash receiptsfrom grain and forage crops,livestock and livestockproducts, governmentpayments, and other sourcesof cash receipts from farming.The total of this group isgross farm operating receipts.

Farm Operating ExpensesFarm operating expenses arethe second group of itemsfound on the incomestatement. Operatingexpenses include outlays forseed, fertilizer, chemicals,machine hire, feed, veteri-nary expense, interest, andseveral other cash farmoperating expense items. Thetotal of these items is grossfarm operating expense.Subtracting gross farmoperating expense from grossfarm operating receipts yieldsnet cash farm operatingincome.

AdjustmentsThe adjustments included onthe income statementaccount for those factors thataffect farm earnings but arenot reflected in a cashtransaction. Included amongthe adjustments are value offarm products consumed bythe farm family, changes ininventory, and changes inaccounts payable andreceivable.

The value of products con-sumed by the family repre-sents production by thebusiness. It is necessary toadd this amount to farmreceipts in order to accuratelyreflect total value of produc-tion by the business. Ex-penses related to producinghome-consumed products aretypically included in farmoperating expense. Thus, the

only adjustment required isto include value of theproducts in gross farmreceipts.

Inventory change is a secondand very important adjust-ment to be made on theincome statement. Inventorychange is determined bycomparing beginning andending inventories from thebalance sheet, the goal beingto determine the increase ordecrease in inventory thatoccurred during the year.Items that may be the sourceof inventory change includefeed and grain, seed, fertil-izer, fuel, livestock, and otherfarm property. A larger end-of-year inventory meanssome farm production isreflected in inventory itemsrather than in farm receipts.That larger inventory mustbe included to arrive at anaccurate measure of farmproduction for the year.

Accounts payable and receiv-able must be considered asthe income statement isdeveloped. If accountspayable have increasedduring the year, this repre-sents expenses incurred (andproperly charged against theyear’s production) but notpaid. This can be resolved byadjusting farm expensesupward to account for theunpaid expense. If accountsreceivable have increasedduring the year, productshave been produced andmarketed but payment hasnot yet been received. Thisrepresents productionattributable to the year thatshould have been reflected infarm receipts. To adjust forthat, it is necessary toincrease receipts in theamount of increase inaccounts receivable.

Net Farm IncomeNet farm income, (farmprofit or loss based onoperating earnings), is netcash operating income (farmreceipts minus farm ex-penses) plus the adjustmentfor value of products con-sumed by the family, plusinventory adjustment, plusadjustments for accountspayable and receivable, andminus depreciation. Theconsolidated income state-ment includes nonfarmincome since employmentoff-the-farm has become anincreasingly importantincome source in recentyears. It may also includewithdrawals for family livingin arriving at a net figure.Choice of farm business,personal, or consolidatedincome statement is at thediscretion of the individualfarm operator.

Income StatementAnalysis

Analysis of the incomestatement involves reviewingseveral variables available oreasily calculated from thatdocument.

Net farm income is the“bottom line” on the incomestatement and a good placeto begin the analysis proce-dure. This figure representsreturn to unpaid operator andfamily labor, equity capital,and management. Over thelong- term, net farm income isthe amount available fordiscretionary use by thefamily and for businessdevelopment. If a withdrawalfor family living is made incomputing net farm income,then net farm incomerepresents the amountavailable for businessexpansion and risk-taking.When family withdrawals are

the flow of expenditures outof the business. Those flowsare important because theyindicate when cash surplusesor deficiencies will occur.

Cash flow says nothing aboutprofitability of the business;profitability information isavailable only from theincome statement. Cash flowincludes no consideration ofinventory change, accountspayable or receivable, ordepreciation. The absence ofthese important adjustmentsmeans that profitabilitydecisions based on cash flowwill be grossly misleading.

A cash flow projection canbe developed in either of twoways. Information from lastyear can be used to estimatecurrent year revenue andexpenses. Adjustment of lastyear’s information will benecessary, depending onprice change and change inthe farming operation. Thisapproach is quick but maynot provide a high degree ofaccuracy.

A more exacting approach isto carefully plan the comingyear’s farm operation andbase the cash flow on thoseplans. Several steps will berequired in this process.

First, the scope of crop andlivestock enterprises shouldbe determined and detailedrevenue and cost data aboutthose enterprises should begathered and organized; thatis, enterprise budgets shouldbe prepared. In addition tonumber of acres or number ofhead of each enterprise,decide on the technology tobe used and the inputs,including machinery opera-tions, that will be neededbased on that technology.This crop and livestockinformation can be used to

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The difference between thequantity “100” and theoperating ratio as a percent-age is the operating margin.For example, if the operatingratio as a percentage is 70,the operating margin is 30(100-70). This marginrepresents the share ofincome that is available tocover family living, businessfixed obligations, andbusiness expansion. Gener-ally, the operating ratio (orpercentage) should be lessthan .75 (or 75 percent)which results in an operatingmargin of 25 percent ormore.

Rate of return on totalcapital is a third analysisvariable computed by makingminor adjustments to netfarm income from theincome statement. Rate ofreturn on capital is net farmincome plus interest paid as afarm operating expense,minus an allowance foroperator labor, with the totaldivided by average capitalinvestment. (Remember thatnet farm income is the returnto unpaid family and operatorlabor, equity capital, andmanagement).

Example: A farm’s incomestatement shows net farmincome of $30,000, interestpaid of $14,000, and anallowance for unpaidoperator labor of $12,000.Total capital investment forthe farm is $340,000. Rate ofreturn to total capital is:

$30,000 +$14,000 - $12,000$340,000=9.41 %

The value computed for rateof return to total capital canbe compared to rates ofreturn for stocks, bonds, orother nonfarm securities.However, that is a valid

comparison only if the farmoperator is willing to liqui-date the business and applythe funds in the nonfarminvestment. Historically,capital invested in farminghas not yielded as muchreturn as capital invested innonfarm securities. A morevalid comparison for acontinuing farm business isone made with other similarfarms in the area or with thelong-term rate of return toagricultural assets. The latterrate has averaged about 6percent for a number ofdecades. (The reader shouldbe aware that this low rate ofreturn to farm investmenthas been compensated tosome degree by appreciationin land value. Unfortunately,this gain can be realized onlyif the farm business isliquidated).

Comparisons with othersimilar farm units must beapproached with a cautiousattitude. It is essential thatthe units selected forcomparison are those withsimilar crop and livestockprograms, using similartechnology, and located insimilar climatic and soilareas.

Figure 3 is a typical farmincome statement. Cash farmreceipts are itemized on theleft side. An adjustment ismade in the receipts sectionfor accounts receivable. Thesum of cash farm receipts andthe adjustment for accountsreceivable is gross farmincome. Cash farm expensesare itemized on the right sideof the form with an adjust-ment for accounts payableincluded.

Depreciation is added to cashfarm expenses to arrive attotal farm expenses. Thatamount is deducted from

gross farm income to arriveat net farm income.

Cash Flow

The cash flow plan is anessential financial manage-ment tool for Pennsylvaniafarmers. It addresses one ofthe most serious financialproblems faced on farmstoday—the control of cashflow. The cash flow plan isthe focal point of the annualfarm planning process. If thecash flow plan is preparedcarefully and in sufficientdetail, it will provide afinancial picture of theoperator’s enterprise selec-tions, input needs, feedrequirements, credit needsand repayment capacity,family living needs, andmarketing plans.

To be most useful, the cashflow should be prepared on aprojected basis; that is, itshould represent a plan forthe future. Actual cash flow(farm receipts and expenses)can then be compared withthe projection to provide anearly check on businessprogress and an opportunityto make timely adjustments ifrequired.

Cash flow should be preparedon both an annual andmonthly basis. The monthlycash flow is of criticalimportance in determiningspecific dates when loans areneeded, when debt can berepaid, and when inputs willbe purchased. The use of thecash flow in estimatingamounts and time of finan-cial transactions causes somepeople to view the documentas a whole-farm budget.

The cash flow projectionestimates the flow of revenueinto the farm business and

Figure 3. Farm Income Statement

Farm Income & Expense Statement

For the period 1/1,1988 to 12/31, 1988

Income $

Livestock & products

Milk 103,855

Dairy Stock 10,300

Crops 1,689

Custom work 405

Rents, share income

Governments payments 769

Misc farm income 1,863

Total farm cash sales 118,881

Closing current accounts receivables $620

Less: opening current accounts receivables $500 120

Total farm sales 119,001

Plus inventory change (ending minus beginning)

Livestock ($110,815 - $110,000) 815

Crops ($46,857 - $40,000) 6,857

Supplies ($700 - $1,000) (300)

Gross farm income (A) 126,373

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Expenses $

Livestock purchases 1,627

Feed 28,173

Other livestock expense 8,124

Crops

Seed 2,963

Fertilizers 6,524

Chemicals

Other

Marketing costs

Custom work, equip. rentals 1,252

Hired labor 7,106

Fuel, oil 4,431

Equip repairs 4,607

Bldg, fence repairs 1,334

Interest 9,662

Electricity 3,375

Taxes, insurance 3,618

Car expenses 1,071

Rent 2,238

Other farm cash expenses 2,857

ToIal farm cash expenses 88,962

Closing current accounts payable $884

Less: opening current accounts payable $500 384

Total farm purchases 89,346

Plus depreciation 17,532

Total farm expenses (B) 106,878

Net farm income (A-B) 19,495

determine annual cash flow.

Step two is to estimatemonthly enterprise incomeand expenses. To arrive atmonthly cash flow, it isnecessary to estimate whenvariable inputs will beneeded and when machineryoperations will be performed.Cost of the inputs andmachinery operations mustbe determined. It is alsonecessary to determine whenproducts will be sold and the

amount of revenue that willbe produced. The result ofthis process is an estimatedmonthly flow of income andexpenses for all crop andlivestock enterprises.

Transactions related tocapital investment must beplanned. This will includepurchases, trades, or sales ofcapital items. Thus, it isnecessary to decide whentractors will be traded, whenthe funds for a new barn will

be needed and their amount,when the old bull will besold, and when a new pickupwill be purchased. Thesetransactions are included incash flow, depending onwhen the transaction occursand the amount of fundsreceived or expended.

Nonfarm earnings should beincluded in the projectedconsolidated cash flow.Wages and salaries earned offthe farm, interest income

received from investments,and other nonfarm sourceincome should be included inthe month they are expectedto be received.

Family living expendituresand taxes are included in themonth they will occur. Timesof extra expense, such asholidays or vacations, shouldbe planned and included inthe consolidated cash flow.

Debt repayment should be

planned and included for themonth in which surplus fundswill be available to makepayment. Planning thisfeature of cash flow requires areview of receipts andexpenses by month todetermine when surplusfunds are expected to beavailable.

The cash flow summary fromthe previous year is helpful in“fine-tuning” the projectedcash flow. If the farmingoperation in the coming yearwill be similar to the opera-tion during the previous year,comparisons may help inmaking adjustments. Thoseadjustments should be basedon expected price or costdifferences, productiondifferences due to weathervariations, or other differ-ences between the year beingprojected and the one justcompleted.

Analysis of Cash Flow

The analysis of cash flow islargely a matter of continu-ous monitoring of receiptsand expenditures andcomparing what actuallyhappens to projected cashflow. A primary advantage ofcash flow analysis is that itprovides an early-warningsystem for the business interms of financial affairs.When major differencesbetween projected and actualcash flow occur, the managershould complete a review offinancial transactions andproduction practices todetermine the reason for thedifference.

The focal points for cash flowanalysis are total cashreceipts, total cash expenses,new debts, interest andprincipal payments, and cashbalance. Projected amounts

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for each of these should becompared with actualexperience at least on amonthly basis. Majordifferences between projectedand actual cash flow mayindicate the need for changesin crop or livestock produc-tion plans, planned newcapital investment, orplanned family livingexpenditures.

Caution must be exercised inusing cash flow to evaluatethe health of a farm business.Cash flow can only indicateif current returns will paycurrent expenses, debt,family living, and othercurrent obligations includedin the cash flow document.An analysis of the health of afarm business should includea review of the balance sheetand the income statement, aswell as the cash flow.

Figure 4 is an annual cashflow projection. It indicatesthe expected sources of cashreceipts and estimated cashexpenses for the year.Principal payments andfamily living are includedand a year-end cash balanceis computed.

Figure 5 is a monthly cashflow. It uses the same broadcategories of income andexpense as the annualdocument, but the estimatesare provided for each month.Thus, the income from saleof milk, expected to be$117,000 for the year, isdivided into estimates of$9,750 per month on themonthly cash flow. Theannual $27,000 feed cost isdivided into estimatedmonthly feed expenseamounts. Cash balance iscomputed on a monthly basisfor the monthly cash flow.

Figure 4. Annual Cash Flow

Annual Cash Flow

Line Cash inflow

Operating income $

Crops

1 Corn

2 Milo

3 Wheat 5,400

4 Soybeans 4,620

5 Cotton

6 Grass & clover seed

7 Hay, silage

8 Other, crop

9 Government payments

Livestock

10 Milk 117,000

11 Eggs, wool

12 Calves 3,540

13 Market hogs

14 Other market livestock

Miscellaneous

15 Custom work

16 Cash rent

17 Other, farm

18 Total operating income Add L 11-17 130,560

Capital sales

19 Breeding beef

20 Breeding hogs

21 Breeding dairy 7,800

22 Machinery & equipment

23 Total capital sales Add L 19-22

24 Total cash income L 18+L 23 138,360

Other income

25 Nonfarm income 6,000

26 Loans

27 Total cash available L 24+25+26 144,360

Operating expenditures $

28 Labor, hired 1,200

29 Machinery repair & maintenance 6,000

30 Building & fence repair 1,200

31 Interest 9,924

32 Hay 2,500

33 Feed bought 27,000

34 Seeds, twine, etc 2,762

35 Crop chemicals 2,482

36 Fertilizer & lime 9,748

37 Machine hire 255

38 Breed fees & livestock supplies 9,900

39 Vet & medicine 1,800

40 Gas, fuel, oil 7,396

41 Rent

42 Taxes 4,000

43 Insurance 800

44 Utilities, elect, phone 3,000

45 Freight & trucking 475

46 Farm auto 500

47 Feeder cattle

48 Assessment 1,380

49 Other expenses (2% subtotal) 1,846

50 Total operating expense Add L 28-49 94,168

Capital expenditures

51 Breeding beef

52 Breeding hogs

53 Breeding dairy

54 Machinery & equipment 9,000

55 Bldgs & land improvements 16,000

56 Total capital expenditures Add L 51-55 25,000

57 Total farm expenditures L 50+56 119,168

Other cash outflow

58 Principal payments 7,000

59 Family living 16,600

60 Total cash outflow L 57+58+59 142,768

Summary

61 Cash balance L 27-60 1,592

62 Accumulated borrowing

Line Cash outflow

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16

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fuel may indicate more severefinancial problems in thenot-too-distant future.

A shortage of working capitalis a second indicator ofapproaching financialtrouble. Working capital isthe difference betweencurrent assets and currentliabilities on the farmbalance sheet. An early signof developing financialproblems is a small, ordecreasing, working capitalposition. The farm operatorwho has a negative workingcapital position can bealmost sure of havingdifficulty obtaining short-term credit.

Failure of earnings (net farmincome) to grow from oneyear to another is an “early-warning” signal of potentialdifficulty. The managershould review enough yearsto determine what hashappened through time. Isthis the first year for theproblem or has it persisted forseveral years? The managershould also establish if theearnings result in a positivecash flow or if the deficiencyis such that existing incomewill not pay operating costs,family living, debt payments,and fixed obligations such astaxes.

The initial issue on whichthe manager may want tofocus attention is theearnings problem. That issue

hold in business assets. Levelof family living expendituresand family goals are impor-tant factors. A family thatexpects frequent recreationaloutings, long vacations, aluxury car, a new residence,and substantial amounts setaside for the children’scollege education requirelarger earnings that a familywith more moderate aspira-tions. Also, the family with80 percent equity in businessassets does not require thehigher level of earningsrequired for debt service ifequity is only 40 percent.

Once the scope of theearnings problem is estab-lished, the manager shouldbecome more specific in his/her review. Is the problemcaused by temporary orpermanent influences?Temporary factors includelow-yields (caused byweather, insects, disease),prices fluctuation, or inven-tory change. If low earningare caused by one or more ofthese temporary conditions,the manager need go nofurther. He/she shoulddetermine the adjustmentsrequired by the temporaryfactors, make those adjust-ments, and proceed withlonger-run operationaldecisions.

Permanent influences usuallyrelate to basic managementdecisions. If the earningsproblem relates to manage-

Part III: Using Information from the Farm Business Analysis

After the tools described inprevious sections have beenapplied to data from aspecific farm business, andanalysis information has beendeveloped, it is necessary tointerpret the results prior tomaking and implementingmanagement decisions. Thatprocess of interpretationinvolves focusing attentionon the information that ismost relevant to the issues athand. The manager’s goal isto understand the environ-ment in which the businessoperates, and to develop astrategy that will help it togrow and prosper in thefuture.

Signs of PendingDifficultiesThere are certain financesigns that provide earlywarnings for pendingfinancial difficulties. A farmoperator who has detailedrecords and who properlyorganizes the informationfrom those records, will beable to note the earlywarning signs in time tomake adjustments. Otherslearn of those signs muchlater, often when it is too latefor easy solutions.

Accounts payable increasing orinability to pay bills on time,are one of the very early signsof approaching financialproblems. The lack ofsufficient funds for paymentof bills for fertilizer, feed, and

may involve very low netfarm income or net farmincome that is less than themanager considers suitablefor the type of farm and sizeof investment. While analysisof the farm business shouldbe a part of the on-goingprocess of farm management,earnings problems (real orperceived) are the mostcommon reason analysisactivity is undertaken. Someof the symptoms of earningsproblems are negative cashflow, net worth not increas-ing from year-to-year, andfailure to service debt on atimely basis.

The income statement is thefocal document in consider-ing problems with earnings.This is the only tool offinancial analysis thatprovides information aboutprofitability of the business.Thus, to study earnings, themanager should start withthe income statement. Netfarm income and thepercentage returned tocapital are two analysisvariables that should bereviewed.

Analysis of the earningsproblem can begin bydetermining the size of theproblem and how long theproblem has persisted. Thesize of the earnings problemoften relates to the lifestyleand expectations of theindividual family as well asthe amount of equity they

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ment, the manager shouldestablish if it is an organiza-tional problem or an opera-tional problem. Organiza-tional problems involve theway resources (land, labor,capital) are used. Operationalproblems relate to day-to-daydecisions such as whenparticular tasks are done,how technology is used, andthe amount of variable inputto be applied to fixedresources.

When the nature of theearnings problem is estab-lished (organizational oroperational), the managermust act to correct theproblem. If low earningsrelate to how the business isorganized, it is necessary tochange the farm plan tobetter utilize availableresources. Enterprise budgetswill help in this process.They indicate the resourcerequirements and potentialearnings from each enter-prise. The manager shouldproceed with a view tomaximizing profitabilitygiven the constraintsimposed by supply of re-sources and availabletechnology.

Excellent planning tools areavailable for the manager’suse in finding the bestorganizational plan for his/her farm. Linear program-ming is a computerizedprocess that can be used tofind the most profitable farmplan given the resourcesavailable. This procedureinvolves development ofbudgets for all possibleenterprises, listing the kindand amount of availableresources, and then solvingmathematically (using thecomputer) for the unique useof resources that maximizesprofit. Linear programmingcan be combined with

computerized transitionalplanning to determine boththe “best” farm organiza-tional plan and the year-to-year changes that should bemade in moving from theexisting plan to a better one.(Linear programming is acomputerized farm planningtool available through PennState county extensionoffices. Transitional planningis available as part of theFinPack group of computer-ized farm planning tools andis also available throughPenn State CooperativeExtension).

If the earnings problemrelates to operational factors,the manager must determinewhy the current operatingsystem is not working andimplement the necessarychanges. This will entail ananalysis of enterprise yields,receipts, costs, and value offarm production per worker.The manager also shouldreview resource use for eachenterprise, with emphasis onproductive efficiency forcrops and livestock andefficiency in use of land,labor, and capital. Cropenterprises should be studiedwith a view to how much ofthe available land is used forhigh-profit crops. Are cropproduction costs undercontrol? Are machinery coststoo high? Are crop yieldscomparable to neighboringwell-managed farms and arecrops marketed efficiently?

Livestock enterprises shouldbe reviewed with particularattention to both economicand production efficiency. Islevel of milk production percow or number of pigsweaned per litter comparableto those of successful farms inthe area? Are livestockproduct sales per worker atefficient levels: 500,000

pounds of milk per worker,for example, in the case ofthe dairy enterprise? Arefixed costs average or belowwhen compared withsurrounding similar farms?

Once the manager hasestablished the cause of thebusiness’ performanceproblem, (organizational oroperational), he/she mustdetermine the courses ofaction that are open to helpimprove the financial healthof the unit. Each farm unit isunique, but three broadcourses of action are avail-able. These are: (1) do abetter job of what is nowbeing done, (2) do more (orless) of what is now beingdone, or (3) liquidate thefarm business and redirectthe use of resources.

If the manager elects to try todo a better job with presentresources, it means concen-tration on improvingefficiency in the operationand management of thebusiness. This includesproduction, marketing, andfinancial management. Thegoal is to increase earningsper unit by increasing yields,improving marketing toincrease revenue, or reducecosts of production. Restruc-turing debt (refinancingshort-term debt) may also bea required part of theadjustment process.

If the manager elects to domore or less with the currentfarm organizational plan, itmeans he/she has recognizeda source of inefficiency andwill act to correct thatproblem. For example, ifthere is excess capacity inmachinery, equipment, orlabor, land may be rented tobetter utilize the under-usedresources. In contrast, somefarmers may have spread

their management andfinances so thin that areduction in size of unitcould improve profits andcash flow.

The decision by a manager to“do something else” is adramatic change and usuallya stress-filled one. It usuallymeans a complete reorganiza-tion of the business assetsand liabilities. Depending onthe individual situation,alternatives such as rentingout land and other assets, off-farm employment, or sellingpart or all the assets may beconsidered.

Specific Solutions forSevere FinancialProblems

Severe financial problemshave no easy solutions. Thesolutions often require drasticsteps. An assumptionunderlying these solutions isthat the problems are relatedto financial difficulties ratherthan management of produc-tion. The following solutionsare intended for farm unitswith more serious financialproblems.

Increasing income withoutincurring added expenses willhelp solve financial prob-lems. In days when farmdebts were small and interestpayments were low, it wasoften possible to obtain apart-time job to solvetemporary financial difficul-ties. The magnitude of debton some farms today makesthis solution less feasible. Itis, however, one alternativethat should be examined,particularly at those farmswhere family labor can besubstituted for operator laborand where the nonfarm jobwill help to reduce the debtburden.

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Examples of this may bewasteland, timberland,minerals, or a land areaseparated from the main farmby a road or other barrier. Itcould also be a set of build-ings. Or, it may be someunused or under-usedmachinery. There may besentimental or other reasonsfor not disposing of theassets. At times, the appre-ciation potential of the assetsmay appear to be large.However, the sale of unpro-ductive assets and using theproceeds to pay off debt is anexcellent way to reduce debtwithout reducing income.

Selling productive assets andreducing size of the business isa difficult approach. Thisalternative is an attempt tosalvage the business byselling off part of the income-producing assets and applyingthe proceeds to debt. Oneintent is reduction of therequired interest and princi-pal payments. However,selling some productive assetssometimes is not feasiblewithout liquidating theentire business. The processof scaling back can createproblems in matchingmachinery and the remainingland. Machinery may need tobe down-sized or used togenerate additional incomethrough custom operation.Thus, the entire processrequires careful planning.The crucial phase of thisplanning is to be sure thatexpenses are cut back morethan income as a result of thepartial liquidation of businessassets.

Maintaining a good workingcapital position is a key goalof financial management.This can be accomplished byproperly structuring debt.When purchasing capitalassets, it is important toproperly finance them, so asto maintain a correct balancebetween short-term andlong-term debt. Onceworking capital has disap-peared, it is often difficult orimpossible to make changes.

Refinancing is a possiblesolution where a shortage ofworking capital and/or short-term debt repaymentcapacity are major problems,and equity exists in long-term assets such as land.However, this can become adangerous habit and can belethal unless the underlyingproduction management orfinancial managementproblems are found andcorrected. Some lenders viewrefinancing as the first steptoward business liquidation.

Obtaining lower interest rates iseasier said than done.However, in some cases it ispossible to obtain FarmersHome Administrationfinancing at lower rates thanoffered by other lenders. Thispossibility varies from oneyear to another depending onFmHA policy. Sometimes itis possible to renegotiateterms of land contracts,particularly if the land waspurchased from a relative. Ifland contracts are altered, itwill be necessary to seek helpfrom a qualified tax account-ant because the change inthe land contract may resultin income tax consequences.

Selling unproductive assets mayhelp on some farm operationswith assets that are currentlynot generating cash income.

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redirecting the use ofresources to other, poten-tially more profitable, uses.

Farm business analysis is theprocess of retrieving, organiz-ing, processing, and compar-ing financial informationfrom a farm business. Theprocess is directed at provid-ing the manager the informa-tion needed to make deci-sions regarding organizationand operation of the farmbusiness.

A farm business analysis mayinvolve the whole farm orone enterprise. The analysismay be completed usingcomparative analysis, ratioanalysis, or projectedanalysis. The latter istypically used with cash flowor the income statement asan estimate of future businessperformance.

Three questions can be usedto outline the process of farmbusiness analysis. They are:where are we? Where do wewant to be? And how do weget there?

The questions imply thatfarm business analysisinvolves reviewing currentresources and the currentoperating plan, setting goals,considering alternatives, anddeciding how to move thebusiness from where it is towhere the operator wants itto be.

The tools of farm businessanalysis include budgets, thebalance sheet, the incomestatement, and cash flow.

Budgets are used to organizeinformation (receipts,expenses, resource use) aboutthe enterprises that may beproduced by the business.The balance sheet provides alisting of assets and liabilitiesof the business. The incomestatement converts cash flowinto business earnings for theperiod under consideration,usually a calendar year. Andcash flow indicates the flowof funds into and from thebusiness. Analysis of informa-tion from these documentshelps the manager todetermine financial health ofthe business and to selectchanges in operations ororganizational structure.

Several early warning signsmay be detected from thefarm business analysis. Theseinclude accounts payableincreasing, a shortage ofworking capital, and failureof earnings to grow from yearto year. These early warningsigns usually point to anearnings problem, the issueon which the manager shouldfocus attention.

If poor performance is thecause of the earningsproblem, the manager mustselect a course of action todeal with the poor perform-ance. These may includedoing a better job of what iscurrently being done, doingmore (or less) of what is nowbeing done, or liquidatingthe farm business and

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Summary

Prepared by Larry C. Jenkins,associate professor of agricul-tural economics and ruralsociology

Where trade names appear, nodiscrimination is intended, and noendorsement by the CooperativeExtension Service is implied.

Issued in furtherance of CooperativeExtension Work, Acts of CongressMay 8 and June 30, 1914, incooperation with the U.S.Department of Agriculture and thePennsylvania Legislature. J. L.Starling, Director of CooperativeExtension, The Pennsylvania StateUniversity.

This publication is available inalternative media on request.

The Pennsylvania State Universityis committed to the policy that allpersons shall have equal access toprograms, facilities, admission, andemployment without regard topersonal characteristics not relatedto ability, performance, orqualifications as determined byUniversity policy or by state orfederal authorities. The Pennsylva-nia State University does notdiscriminate against any personbecause of age, ancestry, color,disability or handicap, nationalorigin, race, religious creed, sex,sexual orientation, or veteran status.Direct all inquiries regarding thenondiscrimination policy to theAffirmative Action Director, ThePennsylvania State University, 201Willard Building, University Park,PA 16802-2801; tel. (814) 863-0471; TDD (814) 865-3175.

File No. IVE1m R2.5M296ps

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