The body of the unit 3.1 Analyzing Farm Records

A number of financial analysis tools can be used when accurate and complete farm records are available. These tools include the balance sheet, income statement and projected monthly cash flow statement (including family living expenses). These three financial statements provide information for making short and long term financial decisions.

3.1.1 The Balance Sheet

Also known as the financial statement or statement of networth. The balance sheet provides an overall financial snapshot of the farm business on a specific date. It lists all of the assets (property) and liabilities (loans) of the business as of the balance sheet date. Income and expense records are not needed for the balance sheet. A value for each asset and the outstanding balance for each liability is given in the balance sheet.

Ideally, the balance sheet should separate assets and liabilities into current asset (less than one year of life), intermediate (one to seven years of life) and long-term (longer than seven years of life, mainly buildings and land) categories and should list cost (original cost less depreciation) and market value (current expected sale price) for each.

The balance sheet gives the farm manager a “snapshot” of the networth on a specific date. The networth is the value of all assets on the farm less the amount of money owed against those assets.

Some of the ratios and relationships on a typical networth statement are examined below.

1. Current Ratio (Liquidity) It is a measure of a business’ ability to meet current debt obligations as they come due without disrupting normal operations.

The ratio is calculated by dividing the current assets by the current liabilities.

Current ratio = Current Assets Current Liabilities

As a general rule, two Naira of current assets to one naira of current liabilities represents a strong ratio. A current ratio of 1.5:1 is good. 1 to 1 is weak and <1 to 1 often results in cashflow problems.

2. Debt to Asset Ratio (Solvency)

It is a measure of the business’ ability to meet its total debt obligations, if all the assets were to be sold. It provides an indication of the business ability to continue in the event of severe financial adversity caused by perils such as drought, excess moisture or a decline in commodity prices. It also shows the percentage of the assets that are financed by outside creditors. The ratio is calculated by dividing the total liabilities by the total assets and is expressed as a percentage.

Debt to Asset ratio = Total liabilities x 100 Total Assets 1

As a general rule, a farm business having under 25% of its assets financed is in a fairly strong position while between 25% to 40% is moderate, and between 40% and 60% is in an increasingly weaker position. The higher the debt ratio, expressed as a percentage the greater the financial risk as a result of the higher borrowing costs.

3. Earned financial progress (profitability)

Earned financial progress refers to the increase in the farm business networth from the beginning of the period to the end of the period as a result of the income earned by the business. The key word is earned’ which excludes changes in networth as a result of an owner’s contributions to the business, the gain on the sale of the assets or the re-

evaluation of the assets including land, buildings and breeding stock. It is important to track the increases to networth that relate directly to income earned by the business as opposed to other adjustments or transactions.

3.1.2 Income Statement

Other names used for this important accounting statement include: a profit and loss statement, an operating statement and an income and expense statement. The income statement lists the income and expenses of a business over a period of time called the accounting period.

Year - to year profits are calculated on the income statement also known as the profit/loss statement. The income statement is used to calculate net cash income, adjusted by changes in inventories and capital items.

The Net farm income refers to the ‘bottom line’ profit that is earned (or projected to earn) by the business during the accounting period. The Net Farm Income provides the answer to the question of how much profit the farm has made or is projected to make, in the business plan.

Analyzing the Net Farm Income as a return on the farm assets and equity (networth) can also be informative. Since the Net Farm Income represents the return the farm earns on investment.

The measures of profitability are as discussed below.

1. Returns on Assets (ROA)

It is a measure of profitability measuring the rate of return that the farm business earns on its average asset base over the period. The higher the return, the more profitable the farm business.

ROA = Net Farm Income + Interest expense - labour x 100 Total Farm Assets (Average) 1 2. Return on Equity (ROE)

It is a measure of the return to the networth (equity) in the business. The farm equity is the capital that could be invested elsewhere (if you were not farming) and so this analysis provides an interesting perspective to see just how good a return a farmer is receiving on his investment in farming as compared to other alternatives. It is calculated by dividing the Net Farm Income less the unpaid labour/management costs, by the

average value of the farm equity (networth) for the period and is expressed as a percentage.

ROE = Net Farm Income - Labour x 100 Farm Equity (average) 1

A return on equity exceeding the return on assets indicated an economical use of borrowed funds. In other words, it paid to borrow money because the return on this borrowed capital was greater than the cost of borrowing.

3. Expense/Revenue Ratio

Shows the percentage of the farm income that is required to cover the operating expenses, excluding the principal and interest payments. The ratio is calculated by dividing the operating expenses by the value of the farm production and is expressed as a percentage.

Expenses/Revenue Ratio = Operating expenses x 100 Value of farm production 1

The value of farm production is the total value of the farm sales less the cost of purchased feeds, grain and market livestock.

3.1.3 Cash flow

The cashflow projection stimulated the anticipated financial activity that will flow through the farm bank account during the accounting period.

The projected monthly cashflow statement is used to look ahead to the next year of operations. By projecting a cashflow for the next year, potential cash shortfalls can be noted and appropriate changes in the farm operation can be analyzed.