Your Net Income Statement Gerry Schwab Barbara Dartt

Your Net Income Statement Gerry Schwab, Barbara Dartt, Sherrill Nott, Roger Betz and other FIRM Ao. E Team Members Day 2 -- morning Farm Financial Management

Net Income Statement Purpose • Measures profitability through calculation of Net Farm Income (NFI) • Summarizes, for a period of time, the income earned and expenses incurred

Net Income Statement Defined • Includes revenues and expenses • Does not include – principal payment – family draws – capital purchases • Does include – depreciation – change in inventory – change in AR & AP • Also known as Profit and Loss Statement

Net Income Statement For: ______________ For time period: From _______ To _______ ***Income Statement*** Cash Farm Income Quantity Value Cash Farm Expense Inventory Changes Crop & Feed Market Receivables Livestock and other Income items Prepaid Payables Total expenses & & accrued Supplies Ending Inventory Beginning Inventory (-) -End Expenses (F) Inventory Change (=) (G)Net Operating profit (E+F) Depreciation and other Capital Adjustments Breeding Machinery Buildings & Other Livestock Equipment Improvements Assets Total Ending Inventory Capital Sales (+) Beginning Inventory (-) Capital purchases (-) (H) Depreciation/cap adj (=) (I) Net farm income (G+H)

Building an Income Statement • NEED: – ALL Cash Income – ALL Cash Expenses – Plus Accurate Beginning and Ending Net Worth Statements to calculate changes in inventory

Issues in Building an Income Statement • Identify clearly the person(s) or the business entity being described • Specify time period being described • Includes only income and expenses plus changes in inventory • Don’t confuse income with assets • Don’t confuse expenses with liabilities

Financial Statement Linkages Historic Projected Dec. 31, 19 X 1 Balance Sheet 12/31/X 1 Dec. 31, 19 X 2 Dec. 31, 19 X 3 Balance Sheet as of 12/31/X 2 Pro Forma Balance Sheet as of 12/31/X 3 Statement of Owner Equity as of 12/31/X 2 (Flow Statement) Income Statement for 12 months ending 19 X 2 Cash Flow Budget for 12 months ending 12/31/X 3 Statement of Cash Flows for 12 months ending 19 X 2 Pro Forma Income Statement for 12 months ending 12/31/X 3 Source: Agricultural Financial Reporting & Analysis

Net Farm Income PURPOSE: Indicator of Farm Business Profit earned during the accounting period Net farm income is the RETURN TO: CALCULATION: Crops, feed market livestock, accounts receivable, and capital adjustments (depreciation) + + - • Unpaid family and operator labor • Unpaid management • Unpaid equity capital $ Gross farm income Ending inventory of Beginning inventory of Ending inventory of accounts payable + Beginning inventory of accounts payable - Cash operating expenses

Net Farm Income % (NFI%) PURPOSE: Indicates profit performance of farm business and may suggest required business size for desired lifestyle withdrawals. Determines how much return for each dollar of sales. Can be used to compare individual farms to industry average, standard, or past performance. CALCULATION : $ Net farm income $ Gross farm income

Rate of Return on Farm Assets (or investment) (ROA or ROI) PURPOSE: To determine the before-tax rate earned by the $ of capital invested in the business. CALCULATION: $ Return on Farm Assets $ Average Total Farm Assets

Rate of Return on Farm Assets • Overall measure of profitability • Non-farm income should not be included • ROI Can vary with structure of business. (Owned land in business) • Market vs. cost method to value farm assets will affect ratio • Must consistently estimate the value of unpaid labor and management • Comparison across farms is more meaningful using market values • Comparison from year to year of an individual farm is more meaningful using cost values

Rate of Return on Equity Capital (ROE) PURPOSE: • To determine the Before-Tax Rate earned by the owner’s equity in the business. • If assets were valued at market value, this rate of return can be compared to ratios that could be earned in the market from alternative investments. CALCULATION: $ Net farm income - $ Opportunity Cost for: Unpaid labor and Management ¸ $ Average Net Worth X 100 (to get on a percentage basis)

Rate of Return on Farm Equity • Measures how well your equity capital is employed in the business • Highly leveraged and under capitalized farms can get wild results • Comparing across farms is more meaningful using market values • Deferred taxes should be included for return using market value -- will show low return without including deferred tax

Value of Farm Production PURPOSE: To provide a measure of Gross Earnings Produced on farm CALCULATION: + $ Gross Farm Income - $ Purchased Feeder Livestock $ Changes in inventory of crops and feed, market livestock, accounts receivable, and breeding livestock

Asset Turnover Ratio PURPOSE: To measure how efficiently farm assets are being used to generate dollars of value-added production. High asset turnover ratio provides increased opportunity for profit. CALCULATION: $ Value of Farm Production ¸ $ Average Total Farm Assets

Operating Profit Margin PURPOSE: To determine the operation efficiency of the business. It indicates the percent profit earned per dollar of value produced. CALCULATION: [($ Net Farm Income + $ Interest Expense - $ Opportunity Cost for unpaid labor and management) $ Value of farm production] x 100

% Return on Investment = Operating Profit Margin X Asset Turnover Rate

If % ROA Is Not Satisfactory Must Increase 1. Operating Profit Margin and/or 2. Asset Turnover Rate

To Increase Operating Profit Margin Needs: • Higher prices Pay Attention To: • Marketing of output and output mix • Lower overhead • Investment & finance • High yields • Low operating expenses • Change enterprise mix: – to higher value crops e. g. specialty or value-added • Production efficiency • Purchasing of input and input mix • External analysis of new business alternatives

To Increase Asset Turnover Ratio Needs: Pay Attention To: • Higher value of • Marketing of output production and yield efficiency • Investment in • Value of durable assets invested assets is too high • Alternative methods of asset control, e. g. renting, sharing, ownership, custom hire • Liquidate nonproductive assets

Term Debt and Capital Lease Coverage Ratio PURPOSE: • Measures ability of the business to pay scheduled financial payments on term debts and capital leases. • If calculated ratio is less than one (100%), potential liquidity problems exist. CALCULATION: +$ Net farm income +$ Non-farm income* +$ Interest on Term Debt +$ Interest on Capital Lease +$ Depreciation Expense -$ Income and Social Security Tax* -$ Owner withdrawals ¸ $ Annual scheduled principal and interest payment on Term Debt and Capital Leases * In analyzing farm business only, you may prefer to exclude nonfarm income. Also adjust downward the income tax obligations associated with the non-farm income.

Capital Replacement and Term Debt Repayment Margin PURPOSE: To determine ability of the business to pay scheduled financial payment on term debts and capital leases. Indicates ability of business to generate funds for capital asset replacements. CALCULATION: + Capital replacement and term debt repayment capacity -$ Payment on unpaid operating debt from a previous period -$ Principal payment on current portion of term debt -$ Principal payment on current portion of capital lease

Operating Expense Ratio PURPOSE: Indicates percentage of gross farm income that was spent for farm operating expenses; used for comparing expense control of the individual farm with the industry average. CALCULATION: ($ Total Farm Operating Expense - $ Farm Interest Expense) $ Gross Farm Income

Depreciation Expense Ratio PURPOSE: Can be used for comparing ownership expense on durable assets with industry average; provides indicator of amount of capitalization investment in depreciable assets. CALCULATION: $ Depreciation expense $ Gross farm income

Interest Expense Ratio PURPOSE: • Indicates percentage of gross farm income spent on interest expense. • Can be used to compare individual farm to industry average, standard, or past performance. CALCULATION: ($ Interest Expense ± Change in Accrued Interest Expense) ¸ $ Gross farm income

Framework for Financial Analysis